[Federal Register Volume 78, Number 142 (Wednesday, July 24, 2013)]
[Rules and Regulations]
[Pages 44730-44771]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-16983]
[[Page 44729]]
Vol. 78
Wednesday,
No. 142
July 24, 2013
Part IV
Securities and Exchange Commission
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17 CFR Parts 200, 230, 239, et al.
Disqualification of Felons and Other ``Bad Actors'' from Rule 506
Offerings; Eliminating the Prohibition Against General Solicitation and
General Advertising in Rule 506 and Rule 144A Offerings; Amendments to
Regulation D, Form D and Rule 156; Final Rules and Proposed Rule
Federal Register / Vol. 78 , No. 142 / Wednesday, July 24, 2013 /
Rules and Regulations
[[Page 44730]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 200, 230, and 239
[Release No. 33-9414; File No. S7-21-11]
RIN 3235-AK97
Disqualification of Felons and Other ``Bad Actors'' From Rule 506
Offerings
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: We are adopting amendments to our rules to implement Section
926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Section 926 requires us to adopt rules that disqualify securities
offerings involving certain ``felons and other `bad actors''' from
reliance on Rule 506 of Regulation D. The rules must be ``substantially
similar'' to Rule 262 under the Securities Act, which contains the
disqualification provisions of Regulation A under the Securities Act,
and must also cover matters enumerated in Section 926 of the Dodd-Frank
Act (including certain state regulatory orders and bars).
DATES: Effective Date: September 23, 2013.
Comment Date: Comments regarding the collection of information
requirements within the meaning of the Paperwork Reduction Act of 1995
should be received on or before August 23, 2013.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form
(http://www.sec.gov/rules/final.shtml);
Send an email to [email protected].
Please include File Number S7-21-11 on the subject line;
or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the
instructions for submitting comments.
Paper Comments
Send paper comments on the Paperwork Reduction Act
analysis in triplicate to Elizabeth M. Murphy, Secretary, Securities
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.
All submissions should refer to File Number S7-21-11. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/final.shtml). Comments will
also be available for Web site viewing and printing in the Commission's
Public Reference Room, 100 F Street NE., Washington, DC 20549, on
official business days between the hours of 10:00 a.m. and 3:00 p.m.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Johanna Vega Losert, Special Counsel,
Karen C. Wiedemann, Attorney Fellow, or Gerald J. Laporte, Office
Chief, Office of Small Business Policy, Division of Corporation
Finance, at (202) 551-3460, Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-3628.
SUPPLEMENTARY INFORMATION: We are adopting amendments to Rules 145,\1\
147,\2\ 152 \3\ and 155; \4\ Rules 501 \5\ and 506 \6\ of Regulation
D;\7\ and Form D \8\ under the Securities Act of 1933 \9\ and to Rule
30-1 \10\ of our Rules of Organization and Program Management.
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\1\ 17 CFR 230.145.
\2\ 17 CFR 230.147.
\3\ 17 CFR 230.152.
\4\ 17 CFR 230.155.
\5\ 17 CFR 230.501.
\6\ 17 CFR 230.506.
\7\ 17 CFR 230.500 through 230.508.
\8\ 17 CFR 239.500.
\9\ 15 U.S.C. 77a et seq.
\10\ 17 CFR 200.30-1.
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Table of Contents
I. Background And Summary
II. Discussion of the Final Amendments
A. Introduction
B. Covered Persons
C. Disqualifying Events
1. Criminal Convictions
2. Court Injunctions and Restraining Orders
3. Final Orders of Certain Regulators
4. Commission Disciplinary Orders
5. Certain Commission Cease-and-Desist Orders
6. Suspension or Expulsion from SRO Membership or Association
with an SRO Member
7. Stop Orders and Orders Suspending the Regulation A Exemption
8. U.S. Postal Service False Representation Orders
D. Reasonable Care Exception
1. Reasonable Care Standard
2. Continuous and Long-Lived Offerings
E. Waivers
1. Waiver for Good Cause Shown
2. Waiver Based on Determination of Issuing Authority
F. Transition Issues
1. Disqualification Applies Only to Triggering Events That Occur
After Effectiveness of the Rule Amendments
2. Mandatory Disclosure of Triggering Events That Pre-Date
Effectiveness of the Rule
3. Timing of Implementation
G. Amendment to Form D
III. Paperwork Reduction Act
A. Background
B. Burden and Cost Estimates Related to the Adopted Amendments
IV. Economic Analysis
A. Background and Summary of the Rule Amendments
B. Economic Baseline
1. Capital Raising Activity Using Rule 506
2. Affected Market Participants
A. Issuers
B. Investors
C. Investment Managers
D. Broker-Dealers
3. Estimated Incidence of ``Bad Actors'' in Securities Markets
Generally
C. Analysis of Final Rules
1. Effects of the Statutory Mandate
2. Discretionary Amendments
V. Final Regulatory Flexibility Act Analysis
A. Reasons for, and Objectives of, the Action
B. Significant Issues Raised By Public Comments
C. Small Entities Subject to the Rule Amendments
D. Reporting, Recordkeeping and Other Compliance Requirements
E. Duplicative, Overlapping or Conflicting Federal Rules
F. Significant Alternatives
VI. Statutory Authority and Text of Amendments
I. Background and Summary
Section 926 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the ``Dodd-Frank Act''), entitled ``Disqualifying
felons and other `bad actors' from Regulation D offerings,'' requires
the Commission to adopt rules to disqualify certain securities
offerings from reliance on Rule 506 of Regulation D.\11\ The Commission
proposed rule amendments to implement Section 926 of the Dodd-Frank Act
on May 25, 2011.\12\ Today we are adopting amendments to Rules 501 and
506 and to Form D to implement Section 926. The disqualification
provisions we are adopting, to be codified as new paragraph (d) of Rule
506,\13\ are generally consistent with the proposal, but will apply
only to triggering events occurring after effectiveness of the rule
amendments (with pre-existing events
[[Page 44731]]
subject to mandatory disclosure) and also reflect some changes in
response to comments.
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\11\ Public Law 111-203, sec. 926, 124 Stat. 1376, 1851 (July
21, 2010) (codified at 15 U.S.C. 77d note).
\12\ See Disqualification of Felons and Other ``Bad Actors''
from Rule 506 Offerings, Release No. 33-9211 (May 25, 2011) [76 FR
31518 (June 1, 2011)].
\13\ Because of the adoption of new Rule 506(c), the
disqualification provisions we adopt today, which were proposed as
Rule 506(c), will be adopted and codified as Rule 506(d).
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Rule 506 is one of three exemptive rules for limited offerings
under Regulation D.\14\ It is by far the most widely used Regulation D
exemption, accounting for an estimated 90% to 95% of all Regulation D
offerings \15\ and the overwhelming majority of capital raised in
transactions under Regulation D.\16\ Rule 506 permits sales of an
unlimited dollar amount of securities to be made without Securities Act
registration, provided that the requirements of the rule are satisfied.
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\14\ The others are Rule 504 and Rule 505, 17 CFR 230.504 and
230.505. Rule 504 permits offerings of up to $1 million of
securities by issuers that are not (i) reporting companies under the
Securities Exchange Act of 1934, (ii) investment companies or (iii)
development stage companies with no specific business plan or
purpose, or whose business plan is to engage in a merger or
acquisition with an unidentified entity or entities. Offerings under
Rule 504 must generally comply with Regulation D requirements
regarding limitations on manner of sale (no general solicitation)
and limitations on resale. The manner of sale and resale limitations
do not apply, however, to offerings that are subject to state-level
registration or that rely on state law exemptions permitting general
solicitation so long as sales are made only to accredited investors.
Rule 505 permits offerings of up to $5 million of securities
annually, without general solicitation, to an unlimited number of
accredited investors and up to 35 non-accredited investors. Rule 505
offerings are subject to the same conditions as apply to Rule 506
offerings, which are described elsewhere, except that non-accredited
investors are not required to be sophisticated and such offerings
are subject to bad actor disqualification provisions.
\15\ In 2012, the Commission received 18,187 initial filings for
offerings under Regulation D, of which 17,203 (approximately 95%)
claimed a Rule 506 exemption.
\16\ Staff of the Commission's Division of Economic and Risk
Analysis estimates that, for 2009, 2010, 2011 and 2012,
approximately $607 billion, $1.003 trillion, $850 billion and $899
billion, respectively, was raised in transactions claiming the Rule
506 exemption, in each case representing more than 99% of funds
raised under Regulation D for the period, based on Form D filings
with the Commission. The amount of capital raised through offerings
under Regulation D and the number of Regulation D offerings may be
considerably larger than what is disclosed in Form D filings because
the filing of a Form D notice is a requirement of Rule 503(a) of
Regulation D [17 CFR 230.503(a)], but is not a condition to the
availability of the exemptions of Regulation D. We understand that
some issuers, therefore, may not make Form D filings for offerings
made in reliance on Regulation D. Further, once a Form D filing is
made, the issuer is not required to file an amendment to reflect a
change that occurs after the offering terminates or a change that
occurs solely with respect to certain information, such as the
amount sold in the offering. For example, if the amount sold does
not exceed the offering size by more than 10% or the offering closes
before a year has passed, the filing of an amendment to Form D would
not necessarily be required. Therefore, the Form D filings for an
offering may not reflect the total amount of securities sold in the
offering in reliance on the exemption.
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Rule 506 historically has permitted sales to an unlimited number of
accredited investors \17\ and up to 35 non-accredited investors, so
long as there was no general solicitation, appropriate resale
limitations were imposed, any applicable information requirements were
satisfied, and the other conditions of the rule were met.\18\ Section
201(a) of the Jumpstart Our Business Startups Act (``JOBS Act'')
required the Commission to eliminate the prohibition against general
solicitation and general advertising for offers and sales of securities
made pursuant to Rule 506, provided that all purchasers of the
securities are accredited investors and the issuer takes reasonable
steps to verify their accredited investor status.\19\ In a separate
release today, we are adopting amendments to Rule 506 and Form D,
including adding new paragraph (c) to Rule 506 to implement JOBS Act
Section 201(a).\20\ As a result, offers and sales of securities
involving the use of general solicitation will be permitted under Rule
506, provided that the requirements of new Rule 506(c) are satisfied.
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\17\ Rule 501 of Regulation D lists eight categories of
``accredited investor,'' including entities and natural persons that
meet specified income or asset thresholds. See 17 CFR 230.501.
\18\ Except as provided under new Rule 506(c), offerings under
Rule 506 are subject to all the terms and conditions of Rules 501
and 502, including applicable limitations on the manner of offering,
limitations on resale and, if securities are sold to any non-
accredited investors, specified information requirements. Where
securities are sold only to accredited investors, the information
requirements do not apply. See 17 CFR 230.502 and 230.506. In
addition, any non-accredited investors must satisfy the investor
sophistication requirements of Rule 506(b)(2)(ii). Offerings under
Rule 506 must also comply with the notice of sale requirements of
Rule 503. See 17 CFR 230.503.
\19\ See Public Law 112-106, sec. 201(a), 126 Stat. 306, 313
(Apr. 5, 2012).
\20\ Eliminating the Prohibition Against General Solicitation
and General Advertising in Rule 506 and Rule 144A Offerings, Release
No. 33-9415 (July 10, 2013).
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``Bad actor'' disqualification requirements, sometimes called ``bad
boy'' provisions, disqualify securities offerings from reliance on
exemptions if the issuer or other relevant persons (such as
underwriters, placement agents and the directors, officers and
significant shareholders of the issuer) have been convicted of, or are
subject to court or administrative sanctions for, securities fraud or
other violations of specified laws. Rule 506 in its current form does
not impose any bad actor disqualification requirements.\21\ In
addition, because securities sold under Rule 506 are ``covered
securities'' under Section 18(b)(4)(D) of the Securities Act, state-
level bad actor disqualification rules do not apply.\22\
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\21\ Rule 507 of Regulation D imposes a different kind of
disqualification specific to Regulation D offerings. Under Rule 507,
any person that is subject to a court order, judgment or decree
enjoining such person for failure to file the notice of sale on Form
D required under Rule 503 is disqualified from relying on Regulation
D. 17 CFR 230.507(a). We are not amending Rule 507 at this time but,
in a separate release the Commission is issuing today, we are
proposing amendments to Rule 507 that would disqualify an issuer
from reliance on Rule 506 if the issuer or its predecessor or
affiliates had conducted a previous securities offering in reliance
on Rule 506 without complying with the Form D filing requirements of
Rule 503. See Amendments to Regulation D, Form D, and Rule 156,
Release No. 33-9416 (July 10, 2013).
\22\ See 15 U.S.C. 77r(b)(4)(D). This provision of Section 18
was added by Section 102(a) of the National Securities Markets
Improvement Act of 1996, Pub. L. No. 104-290,110 Stat. 3416 (Oct.
11, 1996) (``NSMIA''). NSMIA preempts state registration and review
requirements for transactions involving ``covered securities,''
which include securities offered or sold in transactions that are
exempt from registration under Commission rules or regulations
issued under Securities Act Section 4(a)(2) (formerly Section 4(2)).
Rule 506 was originally adopted as a safe harbor under Section
4(a)(2). Section 201(a) of the JOBS Act provides that Rule 506, as
amended in accordance with the mandate of that provision, ``shall
continue to be treated as a regulation issued under'' Section
4(a)(2) of the Securities Act.
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Section 926 of the Dodd-Frank Act instructs the Commission to issue
disqualification rules for Rule 506 offerings that are ``substantially
similar'' to the bad actor disqualification provisions contained in
Rule 262 of Regulation A,\23\ and also provides an expanded list of
disqualifying events, including certain actions by state regulators,
enumerated in Section 926. The disqualifying events listed in Rule 262
cover the issuer and certain other persons associated with the issuer
or the offering, including: issuer predecessors and affiliated issuers;
directors, officers and general partners of the issuer; beneficial
owners of 10% or more of any class of the issuer's equity securities;
promoters connected with the issuer; and underwriters and their
directors, officers and partners. Rule 262 disqualifying events
include:
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\23\ 17 CFR 230.262. Regulation A (17 CFR 230.251 through
230.263) is a limited offering exemption that permits public
offerings of securities not exceeding $5 million in any 12-month
period by companies that are not required to file periodic reports
with the Commission. Regulation A offerings are required to have an
offering circular containing specified information, which is filed
with the Commission and subject to review by the staff of the
Division of Corporation Finance.
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Felony and misdemeanor convictions in connection with the
purchase or sale of a security or involving the making of a false
filing with the Commission (the same criminal conviction standard as in
Section 926 of the Dodd-Frank Act) within the last five years in the
case of issuers and ten years in the case of other covered persons;
Injunctions and court orders within the last five years
against engaging in or continuing conduct or practices in
[[Page 44732]]
connection with the purchase or sale of securities, or involving the
making of any false filing with the Commission;
U.S. Postal Service false representation orders within the
last five years;
Filing, or being named as an underwriter in, a
registration statement or Regulation A offering statement that is the
subject of a proceeding to determine whether a stop order should be
issued, or as to which a stop order was issued within the last five
years; and
For covered persons other than the issuer:
[cir] being subject to a Commission order:
[ssquf] revoking or suspending their registration as a broker,
dealer, municipal securities dealer, or investment adviser;
[ssquf] placing limitations on their activities as such;
[ssquf] barring them from association with any entity; or
[ssquf] barring them from participating in an offering of penny
stock; or
[cir] being suspended or expelled from membership in, or suspended
or barred from association with a member of, a registered national
securities exchange or national securities association for conduct
inconsistent with just and equitable principles of trade.
The disqualifying events specifically required by Section 926 are:
Final orders issued by state securities, banking, credit
union, and insurance regulators, federal banking regulators, and the
National Credit Union Administration that either
[cir] bar a person from association with an entity regulated by the
regulator issuing the order, or from engaging in the business of
securities, insurance or banking, or from savings association or credit
union activities; or
[cir] are based on a violation of any law or regulation that
prohibits fraudulent, manipulative, or deceptive conduct within a ten-
year period; and
Felony and misdemeanor convictions in connection with the
purchase or sale of a security or involving the making of a false
filing with the Commission.
On May 25, 2011, we proposed amendments to Rules 501 and 506 of
Regulation D and Form D to implement Section 926.\24\ We received 44
comment letters in response to our proposal.\25\ In addition, we
received three advance comment letters commenting on Section 926 before
the publication of the proposing release.\26\ These comment letters and
advance comment letters came from a variety of individuals, groups and
constituencies, including state securities regulators, professional and
trade associations, lawyers, academics and individual investors. Most
commenters expressed general support for the proposed amendments and
the objectives that we articulated in the proposing release, but many
suggested modifications to the proposals.
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\24\ See Disqualification of Felons and Other ``Bad Actors''
from Rule 506 Offerings, Release No. 33-9211 (May 25, 2011) [76 FR
31518 (June 1, 2011)].
\25\ The comment letters we received on the proposal are
available on our Web site at http://www.sec.gov/comments/s7-21-11/s72111.shtml. In this release, we refer to these letters as the
``comment letters'' to differentiate them from the ``advance comment
letters'' described in note 26.
\26\ To facilitate public input on its Dodd-Frank Act rulemaking
before issuance of rule proposals, the Commission provided a series
of email links, organized by topic, on its Web site at http://www.sec.gov/spotlight/regreformcomments.shtml. In this release, we
refer to comment letters we received on this rulemaking project in
response to this invitation as ``advance comment letters.'' These
advance comment letters appear on the Commission's Web site under
the heading ``Adding Disqualification Requirements to Regulation D
Offerings, Title IX Provisions of the Dodd-Frank Wall Street Reform
and Consumer Protection Act.''
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Today we are adopting amendments to Rules 501 and 506 of Regulation
D and to Form D to implement Section 926 of the Dodd-Frank Act.\27\ The
amendments we are adopting are generally consistent with the proposal,
with the following principal differences:
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\27\ We are also adopting technical amendments to Rules 145,
147, 152 and 155 to update references to Section 4(2) of the
Securities Act, which was renumbered as Section 4(a)(2) by Section
201(c) of the JOBS Act, Public Law 112-106, sec. 201(c), 126 Stat.
306, 314 (Apr. 5, 2012).
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Disqualification will apply only for triggering events
that occur after the effective date of the amendments; however, pre-
existing matters will be subject to mandatory disclosure;
The rule includes additional disqualifying events for
certain orders of the Commodity Futures Trading Commission (``CFTC'')
and for Commission cease-and-desist orders arising out of scienter-
based anti-fraud violations and violations of Section 5 of the
Securities Act;
Instead of covering all officers of the issuer and of any
compensated solicitors of purchasers of securities, the rule is limited
to executive officers and officers who participate in the offering;
Rather than covering beneficial owners of 10% or more of
any class of the issuer's securities, the rule covers beneficial owners
of 20% or more of the issuer's outstanding voting equity securities,
calculated on the basis of voting power;
For issuers that are pooled investment funds, the rule
covers the funds' investment managers and their principals; and
Disqualification will not apply if the authority issuing
the relevant judgment, order or other triggering directive or statement
determines and advises the Commission that disqualification from
reliance on Rule 506 should not arise as a result.
Part III of the proposing release requested comment on a number of
potential further rule amendments that would result in more uniform bad
actor disqualification rules, including the application of the new bad
actor disqualification standards to offerings under Regulation A,
Regulation E and Rules 504 and 505 of Regulation D. Commenters were
divided in their views with respect to uniform bad actor standards.
Some commenters supported uniformity on the basis that it would enhance
investor protection, increase clarity and consistency in our
regulations and avoid the creation of opportunities for regulatory
arbitrage.\28\ Others opposed it, generally arguing that attempts to
impose uniformity would be premature or inappropriate given the limits
of the Dodd-Frank Act mandate, and that uniformity should be
considered, if at all, in a separate rulemaking.\29\
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\28\ See comment letters from the Federal Regulation of
Securities Committee, Business Law Section of the American Bar
Association (Oct. 4, 2011) (``ABA Fed. Reg. Comm.''); Chris Barnard
(June 1, 2011) (``C. Barnard''); North American Securities
Administrators Association, Inc. (July 25, 2011) (``NASAA''); SNR
Denton LLC on behalf of The Depository Trust & Clearing Corporation
(July 14, 2011) (``DTC''); Better Markets, Inc. (July 14, 2011)
(``Better Markets''); Whitaker Chalk Swindle & Schwartz, PLLC (July
30, 2011 (``Whitaker Chalk''); and Professor J. Robert Brown, Jr.
(Feb. 1, 2012).
\29\ See comment letters from the Committee on Securities
Regulation of the New York City Bar Association (July 14, 2011)
(``NYCBA''); Cravath, Swaine & Moore LLP, Davis Polk & Wardwell LLP,
Gibson, Dunn & Crutcher LLP, Skadden, Arps, Slate, Meagher & Flom
LLP and Wilmer Cutler Pickering Hale and Dorr LLP (July 14, 2011)
(``Five Firms''); SW. Coy Capital, Inc. (July 13, 2011) (``Coy
Capital'').
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We note that the JOBS Act requires us to adopt rules for two new
exemptions from the Securities Act--one for ``crowdfunding'' offerings,
contained in Title III of the JOBS Act, and one for offerings of up to
$50 million in a 12-month period under Section 3(b) of the Securities
Act, contained in Title IV of the JOBS Act. The statutory requirements
for these exemptions contemplate bad actor disqualifications with
language similar to that in Section 926 of the Dodd-Frank Act.\30\ We
are
[[Page 44733]]
working on separate rulemakings for these new exemptions. In light of
these additional rulemakings, we have decided to limit the
disqualification provisions adopted today to Rule 506 offerings. At the
time of those rulemakings, we will have an opportunity to consider to
what extent any bad actor disqualification provisions to be adopted in
connection with those rules should differ from those applicable to Rule
506 offerings. At a later time, we will also have an opportunity to
consider to what extent bad actor disqualifications currently
applicable to Regulation A and Rule 505 offerings should be more
uniform or similar to those applicable to Rule 506 offerings.
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\30\ For crowdfunding, the Commission is directed to adopt rules
establishing disqualification provisions for issuers, brokers and
funding portals seeking to participate in crowdfunding transactions.
The requirement in Section 302(d) of the JOBS Act is identical to
the language of Section 926 of the Dodd-Frank Act. For the new $50
million offering exemption, Section 401(b)(2) of the JOBS Act states
that the Commission may require the issuer to meet certain
conditions including disqualification provisions that are
substantially similar to the disqualification provisions contained
in regulations adopted in accordance with Section 926 of the Dodd-
Frank Act, which we are adopting today.
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II. Discussion of the Final Amendments
A. Introduction
Section 926(1) of the Dodd-Frank Act requires the Commission to
adopt disqualification rules that are substantially similar to Rule
262, the bad actor disqualification provisions applicable to offerings
under Regulation A, and that also cover the triggering events specified
in Section 926. In general, we understand this mandate to mean that the
provisions we adopt to implement Section 926 should have similar
effects as Rule 262, except to the extent that circumstances, such as
the different context for the use of Rule 506 compared to Regulation A
and the need to update or otherwise revise the provisions of Regulation
A, dictate a different approach.
B. Covered Persons
We proposed amendments to Rule 506 of Regulation D to apply the
disqualification provisions required under Section 926 to the following
categories of persons:
The issuer and any predecessor of the issuer or affiliated
issuer;
Any director, officer,\31\ general partner or managing
member of the issuer;
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\31\ Under Rule 405, the term ``officer'' is defined as ``a
president, vice president, secretary, treasurer or principal
financial officer, comptroller or principal accounting officer, and
any person routinely performing corresponding functions with respect
to any organization.'' 17 CFR 230.405. This definition is applicable
to Rule 262 by virtue of Rule 261, 17 CFR 230.261.
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Any beneficial owner of 10% or more of any class of the
issuer's equity securities;
Any promoter connected with the issuer in any capacity at
the time of the sale;
Any person that has been or will be paid (directly or
indirectly) remuneration for solicitation of purchasers in connection
with sales of securities in the offering; and
Any director, officer, general partner, or managing member
of any such compensated solicitor.\32\
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\32\ See Release No. 33-9211, Part II.B (May 25, 2011).
The proposal reflected the categories currently covered by Rule 262 of
Regulation A, with two modifications. First, because Rule 506
transactions may involve the use of persons paid for solicitation of
purchasers, such as placement agents and finders, rather than
traditional underwriters, we added compensated solicitors as a category
of covered persons.\33\ In addition, we proposed to add managing
members to the list of directors, officers and general partners of the
issuer and any underwriter or compensated solicitor to standardize the
treatment of controlling persons of limited liability companies for
disqualification purposes.
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\33\ This is modeled on the disqualification provisions for
offerings under Rule 505 which, like Rule 506 offerings, may involve
the use of placement agents and finders, rather than traditional
underwriters. See 17 CFR 230.505(b)(2)(iii)(B).
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In the proposing release, we solicited comment on whether the rules
should cover a broader or narrower group of persons. We specifically
requested comment on whether the new disqualification provisions should
cover all officers of issuers and covered financial intermediaries, as
Rule 262 currently does, or only some officers (such as executive
officers \34\ and/or officers actually participating in the offering).
We also requested comment on a variety of possible modifications to the
scope of the coverage of shareholders and the possible inclusion of
investment advisers of pooled investment funds.
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\34\ The term ``executive officer'' is defined in Rule 501(f) of
Regulation D (and in Rule 405) to mean a company's ``president, any
vice president . . . in charge of a principal business unit,
division or function (such as sales, administration or finance), any
other officer who performs a policy making function or any other
person who performs similar policy making functions.'' 17 CFR
230.501(f), 230.405.
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Officers. Commenters generally supported limiting the coverage of
the disqualification provisions to executive officers rather than all
officers, citing such issues as the policy benefits of focusing on role
rather than title; \35\ the fact that executive officers of an issuer
are recognized within Regulation D as ``accredited investors'' by
virtue of their participation in the policy-making functions of the
issuer; \36\ the fact that certain entities have a large number of
titular officers who do not have a policy or decision-making role or
any involvement in the relevant offerings; \37\ the potentially heavy
compliance burden associated with broad application, which may make it
difficult for issuers to meet a ``reasonable care'' standard; \38\ and
the obligation it would create for compensated solicitors to disclose
the identities of their employees to issuers.\39\ Some commenters
argued for limiting the rule further as it applies to executive
officers of compensated solicitors, and covering only executive
officers that are engaged in the relevant private placement activities
\40\ or that are responsible for the approval or supervision of Rule
506 offerings.\41\
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\35\ See comment letters from DTC; NYCBA; Sullivan & Cromwell
LLP (July 14, 2011) (``S&C'').
\36\ See comment letter from ABA Fed. Reg. Comm.
\37\ See comment letters from ABA Fed. Reg. Comm.; S&C; Cleary
Gottlieb Steen & Hamilton LLP (July 14, 2011) (``Cleary Gottlieb'');
Lehman & Eilen LLP (July 14, 2011) (``Lehman & Eilen'').
\38\ See comment letters from ABA Fed. Reg. Comm.; Cleary
Gottlieb; Five Firms; S&C; see also comment letter from Kutak Rock
LLP (July 8, 2011) (``Kutak Rock'') (noting that a narrower rule
would be more workable).
\39\ See comment letter from Cleary Gottlieb.
\40\ See comment letters from ABA Fed. Reg. Comm.; NYCBA.
\41\ See comment letter from Lehman & Eilen.
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Two commenters advocated that the new rules mirror Rule 262's
coverage of ``officers,'' as proposed.\42\ These commenters argued both
that a rule ``substantially similar'' to Rule 262 must include officers
and that, based on the presumption of control that attaches to
officers, the ability of officers to set the tone of an organization
and the risk that any officer may be involved with any given offering,
coverage of ``officers'' is needed for the protection of investors.
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\42\ See comment letters from Better Markets; NASAA.
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We also requested comment on whether the coverage of ``officers''
should be limited to officers who participate in or are involved with
the offering. Two commenters addressed this point, acknowledging that
it may be appropriate to cover participating officers to address
investor protection concerns \43\ and that doing so may be preferable
to covering all officers.\44\ Both commenters, however, expressed
concern about the potential difficulty of determining which officers
were
[[Page 44734]]
actually involved with or participating in an offering.\45\
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\43\ See comment letter from Cleary Gottlieb.
\44\ See comment letter from S&C.
\45\ See comment letters from Cleary Gottlieb; S&C.
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We agree with the majority of commenters that, in the context of
Rule 506 offerings, an ``officer'' test based solely on job title would
be unduly burdensome and overly restrictive. Consequently, the final
rule covers only executive officers of covered entities and officers
who participate in the offering. We believe that this coverage is an
appropriate adaptation of the Rule 262 list of covered persons, taking
into account the larger and more complex organizations that are
involved in many Rule 506 transactions \46\ as compared to the smaller
entities that have used Regulation A, and, on that basis, this
provision of the final rule is ``substantially similar'' to Rule 262.
We note that the term ``officer'' in Rule 262 was used as early as
1955, before we adopted the ``executive officer'' concept that we use
in several of our rules.\47\ It also reflects a consideration of costs
and benefits, focusing on situations where the risks that Section 926
is intended to address are at their most pronounced (when bad actors
are performing policy-making functions or are personally involved with
a securities offering) while alleviating the potential compliance
burden by limiting covered persons to a more manageable number who
should generally be easier to identify.
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\46\ There is no cap on the amount of proceeds that may be
raised in an offering relying on Rule 506, and many Rule 506
offerings are larger--in some cases, considerably larger--than would
be permitted under the $5 million aggregate proceeds cap of
Regulation A. For 2012, approximately 41% of Rule 506 offerings
raised more than $5 million, 14% raised more than $50 million and
10% raised more than $100 million.
\47\ See Revision and Consolidation of Regulation A and
Regulation D, Release No. 33-3555 (July 18, 1955) [20 FR 5401 (July
28, 1955)].
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Many issuers will already have determined who their executive
officers are (among other reasons, to provide disclosure about
executive officers in the offering materials), and the officers
participating in an offering will be a question of fact. 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. We anticipate that issuers
should be able to determine which of their own officers are
participating in an offering without undue difficulty, and can exercise
control over which officers participate. We also believe that it is
reasonable to expect that compensated solicitors should be prepared to
confirm which of their officers are participating in an offering as
part of any engagement.
Beneficial Owners of Issuer Equity Securities. The inclusion of
holders of 10% or more of any class of the issuer's equity securities
as covered persons was one of the areas of the proposing release that
attracted the most comment. The majority of commenters did not support
the inclusion of 10% beneficial owners as covered persons for purposes
of the Rule 506 disqualification provisions.\48\ Several commenters
identified a range of potential burdens and costs issuers would face in
identifying 10% beneficial owners. They described the inclusion of 10%
beneficial owners in the context of Rule 506 offerings as unduly
burdensome,\49\ with 10% holders potentially a ``moving target'' for
issuers engaged in continuous sales and regular redemptions.\50\ Others
pointed out that a person could acquire 10% or more of a class of
securities while having no input or control over the company's
management, or even having an adversarial relationship with
management.\51\ One commenter questioned whether public companies would
be able to comply with the rule.\52\ Two commenters urged the
Commission not to include beneficial owners as covered persons at all
in the new disqualification rule.\53\ Some commenters suggested higher
ownership thresholds, from 20% to majority ownership \54\ or a test
based on actual control,\55\ while others argued against an actual
control test and in favor of a bright-line standard based on a stated
percentage of ownership.\56\
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\48\ See comment letters from ABA Fed. Reg. Comm.; Cleary
Gottlieb; Five Firms; Lehman & Eilen; NYCBA; S&C; Whitaker Chalk;
the Investment Program Association (July 14, 2011) (``IPA''); Katten
Muchin Rosenman LLP (July 14, 2011) (``Katten Muchin''); the Real
Estate Investment Securities Association (July 14, 2011)
(``REISA''); Seward & Kissel (July 20, 2011) (``Seward & Kissel'');
the Securities Industry and Financial Markets Association (July 14,
2011) (``SIFMA'').
\49\ See comment letter from Seward & Kissel.
\50\ See comment letters from ABA Fed. Reg. Comm.; IPA.
\51\ See comment letter from Lehman & Eilen; see also comment
letters from ABA Fed. Reg. Comm.; Five Firms; S&C.
\52\ See comment letter from ABA Fed. Reg. Comm. (pointing out
that 10% beneficial owners have no obligation to disclose whether
they are bad actors).
\53\ See comment letters from ABA Fed. Reg. Comm.; Seward &
Kissel.
\54\ See comment letters from ABA Fed. Reg. Comm. (25% ownership
threshold, consistent with the ``control'' presumption in Section
2(a)(5) of the Investment Company Act); NYCBA (20% or 25%); IPA
(20%); Lehman & Eilen (25%, consistent with the thresholds used in
other contexts under the federal securities laws, including Form
BD); Cleary Gottlieb (20%, consistent with the level at which
reporting as a ``passive'' investor under Regulation 13D-G is no
longer permitted); S&C (25%, consistent with the ``control''
presumptions in Form BD and Section 2(a)(9) of the Investment
Company Act); Whitaker Chalk (at least 25%, and disregard if there
is a controlling shareholder or group); SIFMA (at least 25%, which
would accord with Form BD and Section 2(a)(9) of the Investment
Company Act, but would prefer 50%); Seward & Kissel (if coverage of
shareholders cannot be eliminated, increase threshold to a
majority).
\55\ See comment letters from Kutak Rock; REISA; Five Firms; see
also comment letters from Whitaker Chalk (advocating use of the
``affiliate'' standard in Rule 144) and Seward & Kissel (remove 10%
beneficial owners from the list of covered persons, or increase the
ownership threshold to a majority interest).
\56\ See comment letters from Cleary Gottlieb; NYCBA; S&C.
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Some commenters also supported including only voting equity
securities, rather than all equity securities, in determining which
securityholders should be covered persons, generally arguing that only
voting interests confer control.\57\ More specifically, one commenter
recommended that the disqualification provision incorporate the
definition of ``voting security'' contained in Section 2(a)(42) of the
Investment Company Act,\58\ which includes only securities presently
entitling the holder to vote for the election of directors, so that
these rules would apply only to a beneficial owner of equity securities
of an issuer who was entitled to vote for the election of directors (or
their equivalents) of the issuer.\59\ Another suggested that the
provision be limited to voting securities, including general partner
and managing member interests, and exclude passive interests.\60\
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\57\ See comment letters from ABA Fed. Reg. Comm.; Kutak Rock;
Lehman & Eilen; NYCBA; Whitaker Chalk; see also Seward & Kissel
(objecting to the disqualification of pooled investment funds based
on the conduct of a 10% passive equity owner).Comment letter from
NYCBA.
\58\ 15 U.S.C. 80a-2(a)(42).
\59\ See comment letter from ABA Fed. Reg. Comm.
\60\ See comment letter from NYCBA.
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Other commenters supported the proposed inclusion of 10% beneficial
owners of any class of the issuer's equity securities, based on their
presumptive control of the issuer and the mandate to adopt rules that
are ``substantially similar'' to Rule 262, which covers 10% beneficial
owners.\61\
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\61\ See comment letters from Better Markets; DTC; NASAA; Bybel
Rutledge LLP (July 11, 2011) (``Rutledge'').
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We are persuaded, with the majority of commenters, that the Rule
262 standard of 10% ownership of any class of the issuer's equity
securities could be overinclusive, pulling in securityholders who do
not control the activities of the issuer and whose prior bad conduct
may not reflect on the issuer or the current offering. It may
[[Page 44735]]
therefore impose costs and burdens that are not justified in relation
to the potential benefits. We considered in particular the underlying
objectives of the bad actor rules, as well as the potential
administrative complexity of monitoring fluctuating ownership levels
resulting from continuous sales or regular redemptions by certain
issuers, and an issuer's inability to control the actions of an
adversarial or non-compliant securityholder who does not disclose
whether its relationship to the issuer may trigger disqualification.
We agree with most commenters that it would be appropriate to limit
the coverage of securityholders under new Rule 506(d) to those having
voting rights. In light of the range of possible structures and control
arrangements among issuers relying on Rule 506, however, we have not
adopted a specific definition of ``voting securities.'' We intend that
the term should be applied based on whether 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.\62\ For example, we
would consider that securities that confer to securityholders the right
to elect or remove the directors or equivalent controlling persons of
the issuer, or to approve significant transactions such as
acquisitions, dispositions or financings, would be considered voting
securities for purposes of the rule. Conversely, securities that confer
voting rights limited solely to approval of changes to the rights and
preferences of the class would not be considered voting securities for
purposes of the rule.
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\62\ We note that securityholders that have the ability to
control or significantly influence the management and policies of
the issuer through other means will generally be covered by Rule
506(d) in another capacity, such as, for example, as the functional
equivalent of an ``executive officer'' or ``director'' of an issuer.
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We are also concerned that measuring ownership based on the
percentage beneficial ownership of any class of an issuer's securities,
rather than of the issuer's total outstanding securities, may be both
overinclusive and underinclusive. Where a class of securities
represents a very small percentage of the issuer's outstanding equity
securities or voting power, even a large percentage ownership of the
class may not confer the kind of control or influence over the issuer
that the bad actor disqualification rules are intended to address. At
the same time, in the case of a class of supervoting or high vote
securities, ownership of a relatively small percentage of that class
may carry with it control over a relatively large percentage of total
voting power. Accordingly, rather than including beneficial owners of
any class of the issuer's equity securities, the final rule includes
beneficial owners of a specified percentage of the issuer's total
outstanding voting equity securities, calculated on the basis of voting
power. This change will focus the rule on securityholders that have or
share the ability to direct a substantial portion of a vote, and will
avoid the potential overinclusiveness and underinclusiveness of a
share-based or class-based calculation.
After considering commenters' concerns, we have also determined to
raise the beneficial ownership threshold from 10% to 20%, which we
believe is a reasonable and measured approach in the context of Rule
506 offerings that preserves investor protection and provides an
efficient and clear ``bright-line'' test.\63\
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\63\ We note that the 20% threshold aligns with the level of
ownership at which filing as a ``passive investor'' on Schedule 13G
under Regulation 13D-G is no longer permitted. See 17 CFR 230.13d-
1(c).
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Accordingly, the rules we adopt today cover beneficial owners of
20% or more of the issuer's outstanding equity securities, calculated
on the basis of voting power, rather than 10% beneficial owners of any
class of securities, as originally proposed.
We considered, but are not adopting, a standard based on actual
control of the issuer. We share the concern voiced by some commenters
\64\ that a facts-and-circumstances based standard such as actual
control would significantly increase the burden of inquiry associated
with determining whether an offering was disqualified, and may give
rise to unnecessary cost and uncertainty in the application of Rule
506(d). We believe that keeping a ``bright-line'' standard based on a
specified level of ownership reduces the burden of compliance and
responds to the statutory mandate to adopt a rule that is
``substantially similar'' to Rule 262.
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\64\ See comment letters from Cleary Gottlieb; NYCBA; S&C.
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Assessing beneficial share ownership based on ownership of total
outstanding voting securities, based on voting power, rather than
ownership of any class, and increasing the ownership threshold from 10%
to 20% should ease the burden of compliance because there will be fewer
beneficial owners to track. Nevertheless, we do not believe that the
change will diminish the investor protection benefits of Rule 506(d) in
the circumstances posing the highest potential risk to investors, when
securityholders exercise actual control over the issuer, because such
securityholders are likely to be covered persons in some other
capacity. Under the functional definitions of ``director'' and
``executive officer,'' anyone who performs the functions of a director;
controls a principal business unit, division or function of the issuer
or performs policy making functions for the issuer will be a covered
person as a director or executive officer of the issuer. In addition,
as discussed below, shareholders that are ``promoters'' involved with
the issuer will be covered in that capacity.
Investment Managers of Pooled Investment Funds. After further
consideration and review of comment letters, we have determined to
expand the list of covered persons to include investment managers \65\
of issuers that are pooled investment funds; the directors, executive
officers, other officers participating in the offering, general
partners and managing members of such investment managers; and the
directors and executive officers of such general partners and managing
members and their other officers participating in the offering.\66\ We
requested comment on whether to include investment advisers of private
funds, but did not propose to include them. Three commenters supported
such an expansion to promote investor protection,\67\ while six opposed
it on a variety of bases, including that investment advisers are
already subject to fiduciary duties and an extensive regulatory regime;
\68\ that persons who actually control a pooled investment fund issuer
would likely be covered in other capacities, for example as promoters
or through a position with
[[Page 44736]]
the fund's general partner; \69\ and that extending the rule in this
way would be premature, would require a separate rulemaking project or
would violate the ``substantially similar'' requirement.\70\ We agree
that, depending on the circumstances, investment managers that actually
control a pooled investment fund may already be covered persons as
``promoters'' (a concept discussed in greater detail below), or as
``directors'' or ``executive officers'' of the issuer. We also note
that the regulation of investment advisers has been subject to recent
change, so that many investment managers to pooled investment funds
that invest in securities are subject to new reporting and other
obligations.\71\ As a result of our reconsideration and review of the
comment letters, however, we have determined to include investment
managers to pooled investment funds and their principals as covered
persons in the Rule 506 disqualification rules.\72\
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\65\ We are using the term ``investment manager,'' rather than
``investment adviser'' as discussed in the proposing release. Under
Section 202(a)(11) of the Investment Advisers Act of 1940 [15 U.S.C.
80b-2(a)(11)] ``(the ``Advisers Act'')'', an ``investment adviser''
is generally a person or firm that, for compensation, is engaged in
the business of providing advice, making recommendations, issuing
reports, or furnishing analyses on securities. Some pooled
investment funds invest in assets other than securities, such as
commodities, real estate and certain derivatives. In order to ensure
that Rule 506(d) covers the control persons of these funds, we are
using a more general term, which encompasses both investment
advisers and other investment managers.
\66\ We are not adopting a definition of the term ``pooled
investment fund'' as it is used in Rule 506(d). The term has been
used in Form D for years in its ordinary and commonly understood
sense, and we intend to use it in Rule 506(d) in the same way. The
term should not be confused with ``pooled investment vehicle,'' a
term defined more narrowly in Rule 206(4)-8 under the Advisers Act,
17 CFR 275.206(4)-8.
\67\ See comment letters from Better Markets; DTC; NASAA.
\68\ See comment letters from ABA Fed. Reg. Comm.; SIFMA;
Whitaker Chalk.
\69\ See comment letter from Katten Muchin;
\70\ See comment letters from Lehman & Eilen; Rutledge.
\71\ See Reporting by Investment Advisers to Private Funds and
Certain Commodity Pool Operators and Commodity Trading Advisors on
Form PF, Release No. IA-3308 (Oct 31, 2011) [76 FR 71128]; Rules
Implementing Amendments to the Investment Advisers Act of 1940,
Release No. IA-3221 (June 22, 2011) [76 FR 42950].
\72\ See Rule 506(d)(1).
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Most operating companies making Rule 506 offerings are corporations
or limited liability companies that function through their officers,
directors and managing members. By comparison, most pooled investment
funds making Rule 506 offerings are partnerships or other flow-through
entities that have few, if any, employees, and function through their
investment managers and the managers' personnel. In order to provide
equivalent treatment of operating companies and pooled investment
funds, the final rule establishes a new ``bright-line'' category of
presumed control persons for pooled investment fund issuers. This
should make the final rule clearer and easier to apply, and will more
effectively protect investors from bad actors that exercise influence
or control over a pooled investment fund.
Some commenters argued that adding fund investment managers was
unnecessary, given that fund investment advisers are generally subject
to regulation either at the state or the federal level. We believe our
Securities Act disqualification rules are, in many respects, designed
to supplement and build upon other enforcement and regulatory efforts.
For instance, registered broker-dealers subject to limitations on their
activities as a result of disciplinary proceedings could separately be
disqualified from participating in a Rule 506 offering under the
amendments we adopt today. We do not believe that the regulatory scheme
to which a pooled investment fund's investment manager may be subject
is a substitute for bad actor disqualification.
We appreciate that the bad actor provisions in Rule 262 do not
cover investment managers of issuers that are pooled investment funds.
Regulation A, however, is generally not available to or used by pooled
investment funds,\73\ so its disqualification provisions do not have to
address the structure and governance arrangements typical of pooled
investment fund issuers. Analogous disqualification rules under the
Securities Act and the Investment Company Act do, however, include
investment managers of pooled investment funds. For example, the
disqualification provisions of Regulation E (which, like Regulation A,
is an exemption from registration under Section 3(b)(1) of the
Securities Act,\74\ but is designed for use by pooled investment funds
and similar entities) include as covered persons both the investment
adviser to a pooled investment fund issuer as well as partners,
directors, and officers of the investment adviser.\75\ Similarly,
Section 9(a) of the Investment Company Act automatically disqualifies
investment advisers of registered investment companies (and certain
affiliated persons) based on criminal convictions and certain court
orders.\76\
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\73\ Regulation A by its terms is not available to any pooled
investment fund that is an ``investment company registered or
required to be registered under the Investment Company Act of
1940.'' 17 CFR 230.251(a)(4). As a practical matter, it is not
available to other pooled investment funds because most such funds
attempt to maintain that status under either Section 3(c)(1) or
Section 3(c)(7) of that statute, which prohibits them from engaging
in public offerings like those under Regulation A. See Investment
Company Act secs. 3(c)(1), 3(c)(7), 15 U.S.C. 80a-3(c)(1), 80a-
3(c)(7).
\74\ 15 U.S.C. 77c(b)(1).
\75\ 17 CFR 230.602(c).
\76\ See 15 U.S.C. 80a-9(a).
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We also recognize that, depending on the circumstances, some
investment managers of pooled investment funds and certain of their
personnel would be covered already under Rule 506(d), even if we did
not expand the coverage of the rule. For example, some investment
manager firms would be deemed to be ``promoters'' of a pooled
investment fund issuer, and some of their individual principals would
be deemed the functional equivalent of ``directors,'' ``executive
officers'' or ``promoters'' of the issuer. Nevertheless, since we have
concluded that such persons should be covered, we believe it is
preferable to cover them directly, rather than indirectly. This
treatment will avoid the necessity for issuers or others to engage in a
potentially time-consuming, fact-intensive inquiry to determine whether
or not they are within another category of covered persons.
Promoters. Although ``promoters'' are included as covered persons
in Rule 262 \77\ and were included as covered persons in the proposed
rules for that reason, three commenters raised questions about the
treatment of promoters under the new disqualification rules.\78\ One
suggested that directors, executive officers, general partners and
managing members of promoters be included, so that promoters would be
addressed in the rule in the same way as issuers and compensated
solicitors.\79\ The second questioned whether inclusion was necessary
given the breadth of the other categories of covered persons, but
suggested that if promoters are included, the term should be defined so
as to include only persons who are involved with the offering and have
a material financial interest in its outcome (or at a minimum, the rule
should be revised to make clear that fund investment advisers are not
deemed to be promoters).\80\ The third argued that promoters should not
be covered persons unless they are involved in the day-to-day
management of the issuer or will be paid remuneration for the
solicitation of purchasers.\81\
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\77\ Rule 262(b) covers ``any promoter of the issuer presently
connected with it in any capacity.'' The term ``promoter'' is
defined in Rule 405 to mean any person who: (i) Acting alone or
together with others, directly or indirectly takes initiative in
founding or organizing the business or enterprise of an issuer; or
(ii) in connection with the founding or organization of the business
or enterprise of an issuer, directly or indirectly receives 10% or
more of any class of issuer securities or 10% or more of the
proceeds from the sale of any class of issuer securities (not
including securities received solely as underwriting commissions or
solely in exchange for property). The Rule 405 definition applies to
Rule 262 by virtue of Rule 261. 17 CFR 230.261.
\78\ See comment letters from Cleary Gottlieb; SIFMA; S&C.
\79\ See comment letter from Cleary Gottlieb.
\80\ See comment letter from S&C.
\81\ See comment letter from SIFMA.
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We determined not to make any changes in the definition or coverage
of promoters. The category of ``promoter'' is broad, and captures all
individuals and entities that have the relationships with the issuer or
to the offering specified in Rule 405.\82\ In particular, the
definition requires issuers to look through entities and makes it
[[Page 44737]]
unnecessary for us to separately cover the officers, directors and
other control persons of entities that qualify as promoters. Rule 405
defines a promoter as any person--individual or legal entity--that
either alone or with others, directly or indirectly takes initiative in
founding the business or enterprise of the issuer, or, in connection
with such founding or organization, directly or indirectly receives 10%
or more of any class of issuer securities or 10% or more of the
proceeds from the sale of any class of issuer securities (other than
securities received solely as underwriting commissions or solely in
exchange for property). The test considers activities ``alone or
together with others, directly or indirectly''; therefore, the result
does not change if there are other legal entities (which may themselves
be promoters) in the chain between that person and the issuer.
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\82\ See note 77.
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As adopted, the disqualification provisions of Rule 506(d) will
cover the following persons, which we refer to in this release as
``covered persons'':
The issuer and any predecessor of the issuer or affiliated
issuer;
Any director, executive officer, other officer
participating in the offering, general partner or managing member of
the issuer;
Any beneficial owner of 20% or more of the issuer's
outstanding voting equity securities, calculated on the basis of voting
power;
Any investment manager to an issuer that is a pooled
investment fund and any director, executive officer, other officer
participating in the offering, general partner or managing member of
any such investment manager, as well as any director, executive officer
or officer participating in the offering of any such general partner or
managing member;
Any promoter connected with the issuer in any capacity at
the time of the sale;
Any person that has been or will be paid (directly or
indirectly) remuneration for solicitation of purchasers in connection
with sales of securities in the offering (which we refer to as a
``compensated solicitor''); and
Any director, executive officer, other officer
participating in the offering, general partner, or managing member of
any such compensated solicitor.\83\
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\83\ See Rule 506(d)(1).
---------------------------------------------------------------------------
We are also adopting a provision under which events relating to
certain affiliated issuers are not disqualifying if they pre-date the
affiliate relationship.\84\ Rule 262(a)(5) currently provides that
orders, judgments and decrees entered against affiliated issuers before
the affiliation arose do not disqualify an offering if the affiliated
issuer is not (i) in control of the issuer or (ii) under common
control, together with the issuer, by a third party that controlled the
affiliated issuer at the time such order, judgment or decree was
entered. We included a similar provision in the proposal, but clarified
that it applied to all potentially disqualifying events that pre-date
affiliation. All of the commenters that addressed that point were
supportive of the proposal,\85\ and we are adopting it as proposed.
---------------------------------------------------------------------------
\84\ See Rule 506(d)(3).
\85\ See comment letters from ABA Fed. Reg. Comm.; NYCBA;
Rutledge; Whitaker Chalk; Alfaro Oil and Gas LLC (July 14, 2011)
(``Alfaro'').
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We also solicited comment on whether we should apply the
disqualification rules differently to entities that have undergone a
change of control. Five commenters supported differential treatment
following a change of control, primarily arguing that entities act only
through their personnel, and disqualifying events would no longer be
relevant if the persons responsible for the events are no longer in
control.\86\ Another commenter argued that disqualification should
cease to apply following changes of policy, as well as changes of
control.\87\ Three commenters opposed providing different treatment for
entities that have undergone a change of control, generally noting that
it would be difficult to establish whether a change of control had
occurred, that such a provision could be susceptible to abuse, and that
change of control might more appropriately be considered in the context
of an application for waiver of disqualification.\88\ We have decided
to adopt the rules as proposed, as advocated by the latter group of
commenters, and are not providing different treatment for entities that
have undergone a change of control or a change of policy. We wish to
avoid both undue complexity in application of the rules and potential
abuse by bad actors that may claim to have undergone a change of
control when no bona fide change of control has in fact occurred. As
discussed in Part II.E below, we are amending the existing delegation
of authority to the Director of the Division of Corporation Finance so
it will cover waivers of disqualification under Rule 506. We expect
that staff will adopt procedures for the prompt issuance of waivers of
Rule 506 disqualification upon a proper showing that there has been a
change of control and the persons responsible for the activities
resulting in a disqualification are no longer employed by the entity or
exercise influence over such entity.
---------------------------------------------------------------------------
\86\ See comment letters from ABA Fed. Reg. Comm.; Five Firms;
Kutak Rock; Lehman & Eilen, Whitaker Chalk; see also comment letter
from L. Burningham (June 29, 2011) (``Burningham'') (suggesting that
issuers not be disqualified if they have removed bad actors).
\87\ See comment letter from SIFMA (disqualification should
apply only if senior management in control when disqualifying event
arose are still employed by the issuer or a controlling affiliate
continues in a senior management or executive role; disqualification
should also cease to apply if issuer has implemented policies and
procedures designed to prevent occurrence of activities that gave
rise to disqualification, and such policies and procedures have been
approved by a regulator or a court).
\88\ See comment letters from DTC; NYCBA; Rutledge.
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C. Disqualifying Events
Section 926 of the Dodd-Frank Act requires our Rule 506
disqualification provisions to be ``substantially similar'' to those
set forth in Rule 262 of Regulation A, and also to cover certain
criminal convictions and regulatory orders enumerated in Section 926.
In the proposal, the disqualifying events from Rule 262 and Section 926
were combined and integrated in a proposed rule that included the
following disqualifying events:
Criminal convictions (felony or misdemeanor), entered
within the last five years in the case of issuers and ten years in the
case of other covered persons, in connection with the purchase or sale
of any security; involving the making of a false filing with the
Commission; or arising out of the conduct of the business of an
underwriter, broker, dealer, municipal securities dealer, investment
adviser or paid solicitor of purchasers of securities; \89\
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\89\ See Proposed Rule 506(c)(1)(i).
---------------------------------------------------------------------------
Court injunctions and restraining orders, including any
order, judgment or decree of any court of competent jurisdiction,
entered within five years before such sale, that, at the time of such
sale, restrains or enjoins such person from engaging or continuing to
engage in any conduct or practice in connection with the purchase or
sale of any security; involving the making of a false filing with the
Commission; or arising out of the conduct of the business of an
underwriter, broker, dealer, municipal securities dealer, investment
adviser or paid solicitor of purchasers of securities; \90\
---------------------------------------------------------------------------
\90\ See Proposed Rule 506(c)(1)(ii).
---------------------------------------------------------------------------
Final orders issued by state banking, credit union, and
insurance regulators, federal banking regulators, and the National
Credit Union Administration that either create a bar from association
with any entity regulated by the regulator issuing the
[[Page 44738]]
order, or from engaging in the business of securities, insurance or
banking or from savings association or credit union activities; or are
based on a violation of any law or regulation that prohibits
fraudulent, manipulative, or deceptive conduct within the last ten
years;\91\
---------------------------------------------------------------------------
\91\ See Proposed Rule 506(c)(1)(iii).
---------------------------------------------------------------------------
Commission disciplinary orders entered pursuant to Section
15(b) or 15(B)(c) of the Securities Exchange Act of 1934 (the
``Exchange Act'') or Section 203(e) or (f) of the Investment Advisers
Act of 1940 (the ``Advisers Act'') that, at time of the sale, suspend
or revoke a person's registration as a broker, dealer, municipal
securities dealer or investment adviser; place limitations on the
activities, functions or operations of such person; or bar such person
from being associated with any entity or from participating in the
offering of any penny stock; \92\
---------------------------------------------------------------------------
\92\ See Proposed Rule 506(c)(1)(iv).
---------------------------------------------------------------------------
Suspension or expulsion from membership in, or suspension
or a bar from association with a member of, an SRO, i.e., a registered
national securities exchange or a registered national or affiliated
securities association; \93\
---------------------------------------------------------------------------
\93\ See Proposed Rule 506(c)(1)(v).
---------------------------------------------------------------------------
Stop orders applicable to a registration statement and
orders suspending the Regulation A exemption for an offering statement
that an issuer filed or in which the person was named as an underwriter
within the last five years and being the subject at the time of sale of
a proceeding to determine whether such a stop or suspension order
should be issued; \94\ and
---------------------------------------------------------------------------
\94\ See Proposed Rule 506(c)(1)(vi).
---------------------------------------------------------------------------
U.S. Postal Service false representation orders including
temporary or preliminary orders entered within the last five years.\95\
---------------------------------------------------------------------------
\95\ See Proposed Rule 506(c)(1)(vii).
---------------------------------------------------------------------------
We solicited comment on a number of possible modifications to the
list of disqualifying events, such as including additional events and
lengthening or shortening the look-back period associated with each
event. Following is a discussion of each of the disqualifying events
originally proposed, the comments on the proposal and the disqualifying
event as adopted today.
1. Criminal Convictions
Section 926(2)(B) of the Dodd-Frank Act provides for
disqualification if any covered person ``has been convicted of any
felony or misdemeanor in connection with the purchase or sale of any
security or involving the making of any false filing with the
Commission.'' This essentially mirrors the language of Rule 262(a)(3),
which covers criminal convictions of issuers, and Rule 262(b)(1), which
covers criminal convictions of other covered persons. In the proposing
release, we identified two differences between the felony and
misdemeanor conviction provisions of Section 926(2)(B) and Rule 262.
First, Section 926(2)(B) does not include a specific time limit (or
``look-back period'') on convictions that trigger disqualification,
whereas Rule 262 provides a five-year look-back period for criminal
convictions of issuers and a ten-year look-back period for criminal
convictions of other covered persons. Second, Rule 262 includes a
reference to criminal convictions ``arising out of the conduct of the
business of an underwriter, broker, dealer, municipal securities dealer
or investment adviser,'' which does not appear in Section 926.
The proposed rule was based on Rule 262, and provided that a
covered person would be disqualified if such covered person has been
convicted, within ten years before such sale (or five years, in the
case of issuers, their predecessors and affiliated issuers), of any
felony or misdemeanor in connection with the purchase or sale of any
security; involving the making of any false filing with the Commission;
or arising out of the conduct of the business of an underwriter,
broker, dealer, municipal securities dealer, investment adviser or paid
solicitor of purchasers of securities.\96\
---------------------------------------------------------------------------
\96\ Proposed Rule 506(c)(1)(i).
---------------------------------------------------------------------------
The proposed rule included look-back periods of five years for
criminal convictions of issuers (including predecessors and affiliated
issuers) and ten years for other covered persons, which correspond to
Rule 262.\97\ We requested comment on whether the scope of the
provision should be broader or narrower, and whether a longer, or
permanent, look-back period would be appropriate for either issuers or
other covered persons.
---------------------------------------------------------------------------
\97\ Consistent with Rule 262, the look-back period is to the
date of the conviction, not to the date of the conduct that led to
the conviction. The measurement date is the date of the relevant
order or other sanction, not the date of the conduct that was the
subject of the order or other sanction.
---------------------------------------------------------------------------
Commenters were divided in their reaction to this aspect of the
proposal. Most commenters argued that the Commission should stay close
to the language of Section 926 and Rule 262.\98\ One commenter
criticized the proposal as overbroad and suggested ways to narrow
it,\99\ while two commenters urged expansion of the rule to cover a
broader range of criminal convictions.\100\ In an advance comment
letter \101\ and again in its comment letter, NASAA argued for
extension of the disqualification rules to cover all criminal
convictions involving fraud or deceit, as well as convictions involving
the making of a false filing with any state, involving a commodity
future or option contract, or any aspect of a business involving
securities, commodities, investments, franchises, insurance, banking or
finance. One other commenter supported extending coverage to all
criminal convictions involving fraud or deceit.\102\ Three commenters
expressly opposed NASAA's suggested extension on the basis that it
would create a vague and overbroad standard.\103\
---------------------------------------------------------------------------
\98\ See comment letters from Rutledge; Five Firms; S&C; Seward
& Kissel; SIFMA; NYCBA.
\99\ See comment letter from REISA (suggesting limiting false
filings provision to ``intentional, material and misleading'' false
filings and limiting convictions ``arising out of the business'' to
those ``directly related to the offer or sale of securities to
investors'').
\100\ See comment letters from NASAA; Better Markets.
\101\ See advance comment letter from NASAA (Nov. 4, 2010).
\102\ See comment letter from Better Markets.
\103\ See comment letters from NYCBA; S&C; SIFMA.
---------------------------------------------------------------------------
On the length of look-back periods, some commenters argued for a
uniform ten-year period,\104\ some for longer or permanent
disqualification in certain cases,\105\ some for the five- and ten-year
periods proposed,\106\ and some for shorter periods for covered persons
and issuers.\107\ On whether convictions in foreign courts should be
considered, most commenters objected, generally citing due process
concerns and concerns about the cost and burden of inquiry into foreign
proceedings.\108\ Four commenters supported adding foreign convictions,
generally on the basis that conduct outside the United States was as
relevant as conduct within the United States for disqualification
purposes.\109\ One commenter suggested
[[Page 44739]]
that Section 926(2)(B) could be read not to be limited to U.S.
proceedings.\110\
---------------------------------------------------------------------------
\104\ See comment letters from Better Markets; Kutak Rock; see
also comment letters from NASAA (uniform look-back period of at
least ten years); DTC (ten-year look-back except permanent
disqualification for securities fraud and violations of Rule 506).
\105\ See comment letters from DTC (permanent disqualification
for securities fraud and Section 5 violations); J. Davis (June 13,
2011) (suggesting that conviction of any securities violation or
felony should be permanently disqualifying).
\106\ See comment letters from Cleary Gottlieb; Rutledge.
\107\ See comment letters from REISA (uniform five-year period);
D. Sarna (August 23, 2011) (uniform five-year period); SIFMA
(uniform period not longer than one year).
\108\ See comment letters from Cleary Gottlieb; Five Firms;
NYCBA; S&C; Sullivan & Worcester LLP (July 1, 2011) (``S&W'');
SIFMA; Whitaker Chalk.
\109\ See comment letters from C. Barnard; DTC; Better Markets;
advance comment letter from NASAA.
\110\ See comment letter from Rutledge.
---------------------------------------------------------------------------
In sum, most commenters agreed that the final rules should be
closely based on Rule 262. To the extent that commenters advocated
changes from the proposal, however, there was no consensus about what
changes would be desirable or appropriate. We do not believe that the
shift from Regulation A to potentially larger and more complex
transactions under Rule 506 warrants either expanding or narrowing the
scope of coverage of criminal convictions, or modifying the existing
five- and ten-year look-back periods. Given that the rule is required
to be ``substantially similar'' to Rule 262, and that there are no
changes warranted by the application to the Rule 506 context, we are
adopting the provision as proposed.
2. Court Injunctions and Restraining Orders
Under current Rule 262(a)(4), an issuer is disqualified from
reliance on Regulation A if it, or any predecessor or affiliated
issuer, is subject to a court injunction or restraining order against
``engaging in or continuing any conduct or practice in connection with
the purchase or sale of any security or involving the making of any
false filing with the Commission.'' \111\ Similarly, under current Rule
262(b)(2), an offering is disqualified if any other covered person is
subject to such a court injunction or restraining order, or to one
``arising out of the conduct of the business of an underwriter, broker,
dealer, municipal securities dealer or investment adviser.'' \112\
Disqualification is triggered by temporary or preliminary injunctions
and restraining orders that are currently in effect, and by permanent
injunctions and restraining orders entered within the last five
years.\113\
---------------------------------------------------------------------------
\111\ 17 CFR 230.262(a)(4).
\112\ 17 CFR 230.262(b)(2).
\113\ Disqualification is triggered only when a person ``is
subject to'' a relevant injunction or order. Therefore, injunctions
and orders that have expired or are otherwise no longer in effect
are not disqualifying, even if they were issued within the relevant
look-back period. For example, an injunction issued four years
before the relevant securities offering (within the five-year look-
back period), and then lifted before the offering occurred, would
not be disqualifying. The look-back period functions as a cut-off
for injunctions and orders that are still in effect at the time of
an offering. For example, disqualification will not arise from an
injunction issued more than five years before an offering, even if
the injunction is permanent.
---------------------------------------------------------------------------
The proposed provision reflected the substance of these two
provisions in a simplified, combined format. Rule 506 transactions may
involve compensated solicitors, rather than traditional underwriters,
so the proposed rule also covered orders arising out of the conduct of
the business of such compensated solicitors. Under the proposal, an
offering would be disqualified if any covered person is subject to any
order, judgment or decree of any court of competent jurisdiction,
entered within five years before any sale in the offering that, at the
time of such sale, restrains or enjoins such person from engaging or
continuing to engage in any conduct or practice in connection with the
purchase or sale of any security; involving the making of any false
filing with the Commission; or arising out of the conduct of the
business of an underwriter, broker, dealer, municipal securities
dealer, investment adviser or paid solicitor of purchasers of
securities.\114\
---------------------------------------------------------------------------
\114\ Proposed Rule 506(c)(1)(ii).
---------------------------------------------------------------------------
Five commenters recommended adoption of the provisions as
proposed.\115\ Two commenters suggested narrowing the coverage of
orders arising out of the conduct of the business of the listed
financial intermediaries, and limiting the provision either to cases
where there is a finding of fraudulent, manipulative or deceptive
conduct,\116\ or to matters relating to a broker-dealer's activities of
offering securities as a placement or selling agent or
underwriter.\117\ Two commenters argued that court orders and judgments
should not trigger disqualification unless the defendant was afforded
notice and an opportunity to appear.\118\ One such commenter went
further to recommend that all appeals should have been exhausted or the
time for appeal expired before disqualification is triggered.\119\
---------------------------------------------------------------------------
\115\ See comment letters from Cleary Gottlieb; Lehman & Eilen;
NYCBA; Rutledge (arguing, as to look-back periods in particular,
that ``substantially similar'' means that new rules should mirror as
much as possible existing Rule 262 provisions); SIFMA.
\116\ See comment letter from NYCBA (acknowledging that the
limitation they recommend may not be ``substantially similar'' to
Rule 262).
\117\ See comment letter from SIFMA.
\118\ See comment letters from ABA Fed. Reg. Comm.; R. Sherman
(May 25, 2011).
\119\ See comment letter from ABA Fed. Reg. Comm.
---------------------------------------------------------------------------
One commenter requested clarification that disqualification will
apply only for persons specifically named in an order, and not to all
who may be within a class of persons brought within the scope of an
order.\120\ For example, an injunction may be issued against a named
defendant ``and its agents, servants, employees, attorneys, and all
persons in active concert or participation with them who receive actual
notice'' of the order. The commenter requested confirmation that, in
these circumstances, only the named defendant, and not all members of
the class of persons brought within the scope of the order, would be
understood as ``subject to'' the order for disqualification purposes.
---------------------------------------------------------------------------
\120\ See comment letter from ABA Fed. Reg. Comm.
---------------------------------------------------------------------------
We are adopting the provision as proposed. We see no basis for
departing from the coverage and look-back periods that apply under
existing Rule 262. In particular, we have determined not to impose due
process requirements, such as notice and an opportunity to appear, or
to require that all appeals have been exhausted or the time for appeal
expired, as a condition to disqualification. We are sensitive to the
concerns raised by commenters about the risk that ex parte orders may
trigger disqualification. Nevertheless, in light of the statutory
mandate and the Commission's waiver authority, we are not narrowing the
provision. We believe that disqualifying events that arise out of such
circumstances are better addressed through the waiver process.
We are also not persuaded that the shift to potentially larger,
more complex transactions under Rule 506 or other considerations
justifies such a change from the Rule 262 standards. Nor do we want to
add a significant new burden of inquiry, requiring issuers to determine
not just that a covered person is subject to an order, but also that
the order is procedurally adequate. On balance, we believe that the
risk that disqualification may arise from ex parte proceedings could be
better addressed through the waiver process, rather than through
additional requirements for factual inquiry that would affect all
offerings. As for appealable orders, as noted in the proposing release,
we are concerned that suspending disqualification during the pendency
of a potentially lengthy appeals process may significantly undermine
the intended benefits of the rule.\121\
---------------------------------------------------------------------------
\121\ Disqualification would be terminated immediately, however,
if the judgment or order were reversed or vacated.
---------------------------------------------------------------------------
With regard to who would be viewed as subject to an order, we
intend to apply the new provisions consistently with the way that Rule
262 has historically been applied. For disqualification purposes, the
staff has interpreted Rule 262 to limit those considered ``subject to''
an order to only the persons specifically named in the order.\122\
Others who are not specifically
[[Page 44740]]
named but who come within the scope of an order (such as, for example,
agents, attorneys and persons acting in concert with the named person)
will not be treated as ``subject to'' the order for purposes of
disqualification.
---------------------------------------------------------------------------
\122\ For a more general discussion of interpretations of the
meaning of ``subject to'' an order, see note 156 and accompanying
text.
---------------------------------------------------------------------------
3. Final Orders of Certain Regulators
The text of Section 926(2)(A) of the Dodd-Frank Act provides that
Commission requirements for Rule 506 offerings must disqualify any
covered person that
(A) is subject to a final order of a State securities commission
(or an agency or officer of a State performing like functions), a State
authority that supervises or examines banks, savings associations, or
credit unions, a State insurance commission (or an agency or officer of
a State performing like functions), an appropriate Federal banking
agency, or the National Credit Union Administration, that--
(i) bars the person from--
(I) association with an entity regulated by such commission,
authority, agency, or officer;
(II) engaging in the business of securities, insurance, or banking;
or
(III) engaging in savings association or credit union activities;
or
(ii) constitutes a final order based on a violation of any law or
regulation that prohibits fraudulent, manipulative, or deceptive
conduct within the 10-year period ending on the date of filing of the
offer or sale.
As we noted in the proposing release, Section 926(2)(A) is
essentially identical to Section 15(b)(4)(H) of the Exchange Act and
Section 203(e)(9) of the Advisers Act. The only difference is that
Section 926(2)(A)(ii) contains a ten-year look-back period for final
orders based on violations of laws and regulations that prohibit
fraudulent, manipulative and deceptive conduct, while the Exchange Act
and Advisers Act provisions have no express time limit for such orders.
We proposed to reflect Section 926(2)(A) as new Rule
506(c)(1)(iii), with three changes from the text of Section 926(2)(A),
which were intended to eliminate potential ambiguities and allow for
easier application of the rule. First, the proposal specified that an
order must bar the covered person ``at the time of [the] sale,'' to
clarify that a bar would be disqualifying only for as long as it has
continuing effect. Second, the provision measured the look-back period
from the date of the relevant sale, not from ``the date of filing of
the offer or sale,'' as provided in Section 926 of the Dodd-Frank Act,
so it would align with the other look-back periods in the rule.
Finally, the provision required that orders must have been ``entered''
within the look-back period, to clarify that the date of the order, and
not the date of the underlying conduct, was relevant for that
determination.
Under the proposal, an offering would be disqualified if any
covered person is subject to a final order of a state securities
commission (or an agency or officer of a state performing like
functions); a state authority that supervises or examines banks,
savings associations, or credit unions; a state insurance commission
(or an agency or officer of a state performing like functions); an
appropriate federal banking agency; or the National Credit Union
Administration that at the time of such sale, bars the person from
association with an entity regulated by such commission, authority,
agency, or officer; engaging in the business of securities, insurance
or banking; or engaging in savings association or credit union
activities; or constitutes a final order based on a violation of any
law or regulation that prohibits fraudulent, manipulative, or deceptive
conduct entered within ten years before such sale.\123\
---------------------------------------------------------------------------
\123\ Proposed Rule 506(c)(1)(iii).
---------------------------------------------------------------------------
We solicited comment on a number of aspects of the proposed
provision, including the treatment of bars, the definition of the terms
``final order'' and ``fraudulent, manipulative and deceptive conduct,''
and the potential to cover orders of other regulators in addition to
those mandated by Section 926 of the Dodd-Frank Act, particularly the
Commission and the Commodity Futures Trading Commission (``CFTC''). As
discussed in more detail below, we are adopting the provision
substantially as proposed, but adding the CFTC to the list of
regulators whose regulatory bars and other final orders will trigger
disqualification.
CFTC Orders. The proposing release solicited comment on whether
orders of the CFTC or any other regulator not referred to in Section
926 should result in disqualification from Rule 506 offerings. Four
commenters favored adding CFTC orders as a disqualification
trigger.\124\ One noted that ``conduct that would typically give rise
to a CFTC sanction is similar to the type of conduct that would result
in disqualification if it were the subject of action by other
regulators in the securities, banking and insurance fields.'' \125\
Others cited benefits such as improved investor protection,
harmonization of the treatment of regulatory entities, and improved
internal consistency of the bad actor rules.\126\ Another asserted that
it was ``obvious'' that at least some CFTC orders should be covered by
the disqualification rules.\127\ Two of these commenters also
recommended that the rules cover orders of additional regulators.\128\
Seven comment letters opposed adding CFTC orders, generally arguing
that such an addition would not be ``substantially similar'' to Rule
262 and questioning the Commission's legal authority to add such a new
disqualifying event.\129\
---------------------------------------------------------------------------
\124\ See comment letters from Better Markets, Cleary Gottlieb,
NYCBA, NASAA.
\125\ See comment letter from Better Markets.
\126\ See comment letters from Cleary Gottlieb, NASAA.
\127\ See comment letter from NYCBA.
\128\ See comment letters from Better Markets (advocating
addition of orders by other agencies with jurisdiction over
misconduct in the financial services arena, including the Consumer
Financial Protection Bureau and the Federal Trade Commission); NASAA
(advocating addition of orders under state franchise, investment and
finance laws).
\129\ See comment letters from ABA Fed. Reg. Comm.; Five Firms;
Katten Muchin; Lehman & Eilen; Rutledge; Schuyler Roche; SIFMA.
---------------------------------------------------------------------------
We are persuaded that appropriate CFTC orders should be included as
a disqualification trigger in new Rule 506(d). As we noted in the
proposing release, the conduct that would typically give rise to CFTC
sanctions is similar to the type of conduct that would result in
disqualification if it were the subject of sanctions by another
financial services industry regulator. For that reason, CFTC orders
trigger consequences under other Commission rules (for example, both
registered broker-dealers and investment advisers may be subject to
Commission disciplinary action based on violations of the Commodity
Exchange Act).\130\ In addition, the CFTC (rather than the Commission)
has authority over the investment managers of pooled investment funds
that invest in commodities and certain derivatives products; unless
Rule 506(d) covers CFTC orders, regulatory sanctions against those
investment managers are not likely to trigger disqualification. For
these reasons, we believe that including orders of the CFTC will make
the bad actor rules more internally consistent, treating relevant
sanctions similarly for disqualification purposes, and should enable
the disqualification rules to more effectively screen out felons and
bad actors.
---------------------------------------------------------------------------
\130\ See, e.g., Section 15(b)(4)(D) of the Exchange Act (15
U.S.C. 80(b)(4)(C)) and Section 203(e)(5) of the Advisers Act (15
U.S.C. 80-b3(e)(5)).
---------------------------------------------------------------------------
We have decided to include CFTC orders in the bad actor
disqualification scheme by adding the CFTC to the list of regulators in
Rule 506(d)(1)(iii). As a result, disqualification will be triggered
[[Page 44741]]
only by CFTC orders that constitute ``bars'' or ``final orders''
relating to prohibitions on ``fraudulent, manipulative or deceptive
conduct'' on the basis discussed below.
Bars. Our requests for comment focused on whether there was a need
for the Commission to explicitly state that all orders that have the
practical effect of a bar (prohibiting a person from engaging in a
particular activity) should be treated as such, even if the relevant
order did not call it a ``bar.'' We also requested comment on whether
it would be appropriate to provide a cut-off date (for example, ten
years) for permanent bars.
Several commenters urged us to provide additional guidance about
what constitutes a bar.\131\ We believe the statutory language is
clear: bars are orders issued by one of the specified regulators that
have the effect of barring a person from association with certain
regulated entities; from engaging in the business of securities,
insurance or banking; or from engaging in savings association or credit
union activities. Any such order that has one of those effects is a
bar, regardless of whether it uses the term ``bar.'' Orders that do not
have any of those effects are not bars, although they may be
disqualifying ``final orders,'' as discussed below.
---------------------------------------------------------------------------
\131\ See comment letters from Alfaro; ABA Fed. Reg. Comm.;
Rutledge; SIFMA; Whitaker Chalk.
---------------------------------------------------------------------------
Consistent with the proposal, the final rule provides that an order
must bar the person ``at the time of [the] sale'' from one or more of
the specified activities, to make clear that a bar is disqualifying
only for as long as it has continuing effect.\132\ Thus, for example, a
person who was barred indefinitely, with the right to apply to
reassociate after three years, would be disqualified until such time as
he or she is permitted to reassociate, assuming that the bar had no
continuing effect after reassociation. Several commenters argued that
we should impose a cut-off date for permanent bars.\133\ This would
effectively treat permanent bars the same as other final orders, which
are disqualifying only if issued during the look-back period. We are
not, however, departing from the current standard under Rule 262 either
by imposing a look-back period (making all regulatory bars issued
within a specified period before a sale disqualifying, even if no
longer in effect) or by imposing a cut-off date (which would make bars
no longer disqualifying after the requisite time period has passed,
even if the bar is permanent or otherwise still in effect). Under Rule
262, bars are disqualifying for as long as they are in effect but no
longer, matching the period of disqualification to the duration of the
regulatory sanction. We are adopting the same approach for Rule 506.
Persons who are subject to an indefinite bar who do not wish to
reassociate but do wish to participate in Rule 506 offerings could
consider applying for a waiver.
---------------------------------------------------------------------------
\132\ This accords with the Commission's interpretive position
on Rule 262. See Release No. 33-6289 (Feb. 13, 1981) [46 FR 13505,
13506 (Feb. 23, 1981)] (Commission consistently has taken the
position that a person is ``subject to'' an order under Section
15(b), 15B(a) or (c) of the Exchange Act or Section 203(e) or (f) of
the Advisers Act only so long as some act is being performed (or not
performed) pursuant to the order). See note 156 and accompanying
text.
\133\ See comment letters from ABA Fed. Reg. Comm.; Katten
Muchin; Lehman & Eilen; Rutledge; Schuyler, Roche & Crisham, P.C.
(July 14, 2011) (``Schuyler Roche''); SIFMA.
---------------------------------------------------------------------------
We recognize that, in the proposal and in the final rule, the
treatment of court injunctions and restraining orders, on one hand, and
regulatory bars and orders, on the other hand, is different in some
respects. Court injunctions and restraining orders are subject to a
five-year look-back period, which functions as a cut-off (i.e.,
injunctions and restraining orders issued more than five years before
the relevant sale are no longer disqualifying, even if they are still
in effect or permanent). The treatment of court injunctions and
restraining orders is consistent with Rule 262, and therefore responds
to the requirement to develop a ``substantially similar'' rule, while
the treatment of regulatory bars and orders is specifically mandated by
Section 926 of the Dodd-Frank Act. Commenters did not generally support
harmonizing our approach to court injunctions and restraining orders
with the mandated treatment of regulatory bars and orders, and we do
not believe that the shift from Regulation A to Rule 506 offerings
justifies extending the time period for disqualification associated
with court injunctions and restraining orders.
Final Orders. Section 926 of the Dodd-Frank Act does not specify
what should be deemed to constitute a ``final order'' that triggers
disqualification. The proposal included an amendment to Rule 501 to
provide a definition of ``final order,'' based on the definition that
the Financial Industry Regulatory Authority (``FINRA'') uses in forms
that implement language in Section 15(b)(4)(H) of the Exchange Act,
which is identical \134\ to the language used in Section 926.\135\
Under the proposal, ``final order'' would mean ``a written directive or
declaratory statement issued pursuant to applicable statutory authority
and procedures by a federal or state agency described in Sec.
230.506(c)(1)(iii), which constitutes a final disposition or action by
that federal or state agency.''
---------------------------------------------------------------------------
\134\ Note, however, that Section 15(b)(4)(H) does not contain a
look-back period, unlike the 10-year look-back period specified in
Section 926(2)(A)(ii).
\135\ The definition of ``final order'' used by FINRA applies to
Forms U4, U5 and U6, which are used for reporting the disciplinary
history of broker-dealers and associated persons under Exchange Act
Section 15(b)(4)(H). Form U4 is the Uniform Application for
Securities Industry Registration or Transfer, used by broker-dealers
to register associated persons. Form U5 is the Uniform Termination
Notice for Securities Industry Registration, used by broker-dealers
to report the termination of an associated person relationship. Form
U6 is the Uniform Disciplinary Action Reporting Form, used by SROs
and state and federal regulators to report disciplinary actions
against broker-dealers and associated persons.
---------------------------------------------------------------------------
The proposing release requested comment on other potential
approaches to the term ``final order,'' such as whether the rule should
consider orders final only if they are non-appealable, and whether the
rule should cover only orders issued in a process that provides for
certain due process rights, such as notice, a right to be heard, and a
requirement for a record with written findings of fact and conclusions
of law. We also queried whether disqualifying matters that arose in the
context of a settlement with a regulatory authority should be treated
the same as non-settled matters. The proposing release also discussed
whether the Commission should defer to the regulator issuing the order
to determine whether the issued order was a ``final order'' for
purposes of disqualification in Rule 506.
Several commenters agreed that a definition of ``final order''
would be helpful in promoting uniform and predictable treatment of
regulatory actions.\136\ Four commenters were generally supportive of
the proposed definition.\137\
---------------------------------------------------------------------------
\136\ See, e.g., letters from NYCBA; Rutledge; SIFMA.
\137\ Letters from C. Barnard; Rutledge; Better Markets; Munck
Carter, LLP (July 14, 2011) (``Munck Carter'').
---------------------------------------------------------------------------
Two commenters suggested adding minimum procedural standards to the
definition of ``final order.'' \138\ One advocated building ``basic due
process elements'' into the definition by adding the concept of notice
and an opportunity for a hearing.\139\ This commenter suggested that,
in order to ensure that settled matters would be treated the same as
litigated matters, the definition should require ``an opportunity for
hearing'' rather than some specified actual proceeding.\140\ The other
commenter recommended that, for an order to constitute a ``final
order,'' a regulator ``must have made a
[[Page 44742]]
finding of fact and set forth conclusions of law on a record.'' \141\
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\138\ Letters from NYCBA; SIFMA.
\139\ Letter from NYCBA.
\140\ Id.
\141\ Letter from SIFMA.
---------------------------------------------------------------------------
Taking into account the potential impact of disqualification on
issuers and other market participants, we are persuaded that the
definition of ``final order'' should be limited to orders issued under
statutory authority--including statutes, rules and regulations--that
provides for notice and an opportunity for hearing.\142\ As a result,
under our final definition, ex parte orders issued under statutory
authority that does not provide for notice and an opportunity for
hearing will not trigger disqualification. We are not, however,
imposing procedural requirements beyond a basic requirement that notice
and opportunity for hearing be provided for in the statutes, rules and
regulations under which an order is issued. The proceedings covered in
Rule 506(d)(1)(iii) take many different forms, and it would not be
appropriate for our rules to impose procedural requirements that may
not be met by the proceedings of every state or federal regulator whose
orders are required to trigger disqualification under Section 926 of
the Dodd-Frank Act. We are also not requiring that a hearing actually
have occurred. There may be no hearing, for example, in the context of
a settled matter; however a settlement is considered for this purpose
to have been made after an opportunity for hearing. The basic
requirement we have included should be sufficient to address the
fundamental fairness concern.
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\142\ See Rule 501.
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We believe that focusing on the nature of the relevant legal
authority for an order rather than the particular facts and
circumstances surrounding the order will provide more certainty to
issuers seeking to determine whether a covered person subject to an
order is in fact subject to a ``final order'' that would be
disqualifying. An issuer would only need to determine whether the
statutory authority provided for these procedural safeguards, not
whether in fact notice was given and an opportunity for hearing was
provided. This approach is consistent with comment we received
stressing the importance of making the disqualification provisions
clear and simple to administer, based on ``bright line'' provisions or
an ``objective test'' wherever possible.\143\ The focus on legal
authority rather than the facts of each case will also likely reduce
the incidence of covered persons, in an effort to participate in an
offering, claiming procedural irregularities where such irregularities
did not occur. A market participant that is subject to an order that
was issued without in fact receiving notice and an opportunity for
hearing will be able to challenge the order itself, and may also seek a
waiver of disqualification from the Commission.
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\143\ Letter from NYCBA
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We do not believe that limiting final orders in this way will
compromise investor protection because, in most instances, ex parte
orders are of short duration and will either expire or be replaced by a
subsequent order that would meet our procedural requirements.
Commenters were divided on the question of whether orders should be
deemed final if they are still subject to appeal. Three commenters
objected to adding a requirement that final orders be non-appealable,
generally on the basis that the resulting delay could compromise
investor protection.\144\ Three other commenters argued that the
definition of ``final order'' should be limited to non-appealable
orders.\145\ We remain concerned that delay incident to the appeals
process could undermine the intended benefits of the rule, and are
therefore adopting the definition of ``final order'' without a
requirement that the order be non-appealable.\146\
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\144\ Letters from C. Barnard; NYCBA; Rutledge.
\145\ Letters from SIFMA; REISA; Alfaro.
\146\ See Rule 501.
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As adopted, the definition of ``final order'' contained in new Rule
501(g) provides that ``final order'' shall mean a written directive or
declaratory statement issued by a federal or state agency described in
Sec. 230.506(d)(1)(iii) under applicable statutory authority that
provides for notice and an opportunity for hearing, which constitutes a
final disposition or action by that federal or state agency.
Fraudulent, Manipulative or Deceptive Conduct. Section
926(2)(A)(ii) of the Dodd-Frank Act provides that disqualification must
result from final orders of the relevant regulators that are ``based on
a violation of any law or regulation that prohibits fraudulent,
manipulative, or deceptive conduct.'' In light of the specificity of
the language of Section 926, the proposal did not include standards or
guidance with respect to what constitutes ``fraudulent, manipulative or
deceptive conduct.''
In the proposing release we solicited comment on whether the rule
should provide a definition for ``fraudulent, manipulative or deceptive
conduct'' and, if we provided a definition, what should be included in
such a definition. Recognizing that Section 926(2)(A)(ii) refers to the
final orders of the relevant regulators, the proposing release also
requested comment on whether the ``fraudulent, manipulative or
deceptive conduct'' determination should be considered and decided only
by the relevant regulator issuing the final order. In particular, we
asked whether ``fraudulent, manipulative or deceptive conduct'' should
be understood to require knowing misconduct or scienter, and noted the
concern expressed by some commenters that ``technical or administrative
violations'' should not be a source of disqualification.\147\
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\147\ See advance comment letter from Investment Program
Association (Mar. 2, 2011) (available at http://www.sec.gov/comments/df-title-ix/regulation-d-disqualification/regulationddisqualification-3.pdf). See also Record of Proceedings
of 29th Annual SEC Government-Business Forum on Small Business
Capital Formation, at 18 (Nov. 18, 2010) (remarks of Deborah
Froling) (available at http://www.sec.gov/info/smallbus/sbforumtrans-111810.pdf).
---------------------------------------------------------------------------
Some commenters believed that the Commission should provide
standards for fraudulent, manipulative or deceptive conduct to clarify
and limit the types of orders by state and federal regulators that will
trigger disqualification.\148\ These commenters supported a definition
that requires scienter, generally modeled on the scienter standards of
Section 10(b) of the Exchange Act and Rule 10b-5.\149\ Many of these
commenters also argued that violations they characterized as
``technical'' or ``administrative,'' such as late filings and books and
records violations, without a requirement of scienter, should not give
rise to disqualification.\150\ On the other hand, a commenter who
opposed defining ``final order'' to include scienter pointed out that
scienter is not required for all state securities law violations or for
violations of federal banking regulations (where the standard is unsafe
or unsound banking practices or breach of fiduciary duty), so limiting
the definition of fraudulent, manipulative or deceptive conduct to
scienter-based violations would potentially result in orders by those
regulators not giving rise to disqualification even though they are
explicitly mandated to be covered by Section 926. In the commenter's
view, this would be contrary to Congressional
[[Page 44743]]
intent and the plain language of Section 926.\151\
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\148\ See comment letters from Alfaro; ABA Fed. Reg. Comm.; Five
Firms; the Managed Funds Association (Aug. 12, 2011) (``MFA'');
NYCBA; REISA; SIFMA; S&C; Whitaker Chalk.
\149\ See comment letters from ABA Fed. Reg. Comm.; Five Firms;
MFA; NYCBA; REISA; SIFMA; S&C; Whitaker Chalk. See also comment
letter from Cleary Gottlieb (supporting a scienter requirement for
all regulatory orders, including orders of the Commission, with an
exception for Commission orders related to violations of Section 5
of the Securities Act).
\150\ See, e.g., comment letters from Five Firms; MFA; SIFMA.
\151\ See comment letter from Rutledge.
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We do not believe that Section 926(A)(ii) is limited to matters
involving scienter. Scienter is not a requirement under Section
15(b)(4)(H) of the Exchange Act or Section 203(e)(9) of the Advisers
Act, from which the language of Section 926 is drawn. Commission orders
are issued under these sections based only on the existence of a
relevant state or federal regulatory order; the Commission has stated
that, while the degree of scienter involved is a factor in determining
what sanction is appropriate,\152\ the Commission can order sanctions
even where scienter is not an element of the underlying state anti-
fraud law violation.\153\ Scienter may also not play a similar role in
other areas of regulation specified in Section 926(A)(ii), such as
insurance, banking and credit union regulation, as it does under the
federal securities laws. We do not believe it is appropriate to limit
the provision to matters involving scienter absent a clear statutory
direction to do so, particularly when the relevant language has been
construed in other contexts not to be so limited, and when imposing
such a limitation may result in excluding regulatory orders that are
explicitly mandated to be covered by the new rules. Accordingly, the
final rules do not include a definition of ``fraudulent, manipulative
or deceptive conduct'' and in particular do not limit ``fraudulent,
manipulative or deceptive conduct'' to matters involving scienter.
---------------------------------------------------------------------------
\152\ Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979),
aff'd on other grounds, 450 U.S. 91 (1981).
\153\ See In the Matter of Mitchell M. Maynard and Dorice A.
Maynard, Release No. IA-2875 (May 15, 2009).
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Final Rule. As adopted, Rule 506(d)(1)(iii) provides that
disqualification will arise if a covered person is subject to a final
order of a state securities commission (or an agency or officer of a
state performing like functions); a state authority that supervises or
examines banks, savings associations, or credit unions; a state
insurance commission (or an agency or officer of a state performing
like functions); an appropriate federal banking agency; the U.S.
Commodity Futures Trading Commission; or the National Credit Union
Administration that:
At the time of the sale, bars the person from association
with an entity regulated by such commission, authority, agency, or
officer; engaging in the business of securities, insurance or banking;
or engaging in savings association or credit union activities; or
Constitutes a final order based on a violation of any law
or regulation that prohibits fraudulent, manipulative, or deceptive
conduct entered within ten years before the sale.\154\
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\154\ Rule 506(d)(1)(iii).
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4. Commission Disciplinary Orders
Rule 262(b)(3) of Regulation A imposes disqualification on an
issuer if any covered person is subject to an order of the Commission
``entered pursuant to section 15(b), 15B(a), or 15B(c) of the Exchange
Act, or section 203(e) or (f) of the Investment Advisers Act.'' \155\
Under these provisions (other than Section 15B(a), discussed below),
the Commission has authority to order a variety of sanctions against
registered brokers, dealers, municipal securities dealers and
investment advisers and their associated persons, including suspension
or revocation of registration, censure, placing limitations on their
activities, imposing civil money penalties and barring individuals from
being associated with specified entities and from participating in the
offering of any penny stock.
---------------------------------------------------------------------------
\155\ 17 CFR 230.262(b)(3) (citing 15 U.S.C. 78o(f), 78o(4)(a),
78o(4)(c), 80b-3(e) and 80b-3(f)). Section 21B(a) of the Exchange
Act, 15 U.S.C. 78u-2(a)(1), and Section 203(i)(1)(A) of the Advisers
Act, 15 U.S.C. 80b-3(i)(1)(A), give the Commission authority to
impose civil money penalties in these disciplinary proceedings.
---------------------------------------------------------------------------
Our proposed rule was based on Rule 262(b)(3), but eliminated the
anomalous reference to Section 15B(a), which is not a source of
sanctioning authority, and codified the prior interpretive position
that disqualification would continue only for as long as some act is
prohibited or required to be performed pursuant to the order (with the
consequence that censures and orders to pay civil money penalties,
assuming the penalties are paid in accordance with the order, are not
disqualifying, and a disqualification based on a suspension or
limitation of activities expires when the suspension or limitation
expires).\156\ Under the proposed rule, an offering would be
disqualified if any covered person is subject to an order of the
Commission entered pursuant to section 15(b) or 15B(c) of the Exchange
Act or section 203(e) or (f) of the Advisers Act that, at the time of
such sale, suspends or revokes such person's registration as a broker,
dealer, municipal securities dealer or investment adviser; places
limitations on the activities, functions or operations of such person;
or bars such person from being associated with any entity or from
participating in the offering of any penny stock.\157\
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\156\ See Proposed Rule 506(c)(1)(iv); Release No. 33-6289 (Feb.
13, 1981) [46 FR 13505, 13506 (Feb. 23, 1981)] (in adopting
amendments to Rule 252 of Regulation A, the predecessor to Rule 262,
the Commission noted ``[i]n those instances where persons are
subject to orders containing no definite time limitations, the
Commission has consistently taken the position that a person is
subject to an order only so long as some act is being performed
pursuant to such order, [such as] establishing procedures to assure
appropriate supervision of salesmen and reporting on such
procedures.'') The staff of the Division of Corporation Finance has
taken the same view. See Release No. 33-6455, Question 66 (Mar. 3,
1983) [48 FR 10045, 10053 (Mar. 10, 1983)] (in interpretive release
on Regulation D, the staff advised that censure has no continuing
force and thus censured person is not ``subject to an order of the
Commission entered pursuant to section 15(b)'' within the meaning of
Rule 505); Howard, Prim, Rice, Nemerovski, Canady & Pollak, SEC No-
Action Letter, 1975 WL 11300 (Jan. 8, 1975, publicly available Feb.
11, 1975) (Rule 252 does not comprehend a situation where an
underwriter of a Regulation A offering has stipulated to a consent
order in a Commission administrative proceeding providing only for a
censure, with no suspension or other sanction); Samuel Beck, SEC No-
Action Letter, 1975 WL 11471 (May 15, 1975, publicly available June
24, 1975).
\157\ Proposed Rule 506(c)(iv).
---------------------------------------------------------------------------
We requested comment on the appropriateness of codifying the
interpretive position and imposing any look-back period for Commission
disciplinary sanctions. Specifically, we requested comment on whether
the rules should provide that orders to pay civil money penalties are
disqualifying if the penalties are not paid as ordered. The proposal
drew relatively little comment, all of which was supportive.\158\ We
are adopting the rule as proposed, now numbered Rule 506(d)(1)(iv).
---------------------------------------------------------------------------
\158\ See comment letter from Rutledge; see also comment letters
from Lehman & Eilen; SIFMA.
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5. Certain Commission Cease-and-Desist Orders
Section 926 of the Dodd-Frank Act mandates that bad actor
disqualification result from final orders issued within a ten-year
period by the state and federal regulators identified in Section
926(2)(A) of the Dodd-Frank Act. The state and federal regulators
listed in Section 926 include: State authorities that supervise banks,
savings associations, or credit unions; state insurance regulators;
appropriate federal banking agencies; and the National Credit Union
Administration. The Commission is not included in the Section 926(2)(A)
list of regulators. Although we did not propose specific amendments to
the rule to include the Commission, we explained that adding the
Commission's cease-and-desist orders to the disqualification provisions
could further enhance the investor protection intent of the
disqualification provisions and would contribute to creating an
internally consistent set of rules that would treat relevant sanctions
[[Page 44744]]
similarly for disqualification purposes. In the proposing release, we
pointed out in particular that orders issued in stand-alone Commission
cease-and-desist proceedings \159\ are not disqualifying under current
bad actor disqualification provisions,\160\ and the proposal did not
include such orders as disqualifying for purposes of Rule 506
offerings.
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\159\ In cease-and-desist proceedings, the Commission can issue
orders against ``any person,'' including entities and individuals
outside the securities industry, imposing sanctions such as
penalties, accounting and disgorgement or officer and director bars.
In contrast, administrative proceedings are generally limited to
regulated entities and their associated persons.
\160\ Current provisions also do not cover other types of
Commission actions. For example, the Commission has authority under
Section 9(b) of the Investment Company Act to bring proceedings
against ``any person'' and may impose investment company bars, civil
penalties and disgorgement under Sections 9(d) and (e) of the
Investment Company Act. 15 U.S.C. 80a-9(b), (d) and (e). The
Commission also has authority under Rule 102(e) of its Rules of
Practice to censure persons (such as accountants and attorneys) who
appear or practice before it, or to deny them the privilege of
appearing before the Commission temporarily or permanently. 17 CFR
201.102(e). Orders under these sections are not disqualifying under
Rule 262.
---------------------------------------------------------------------------
Our request for comment covered a range of issues, including
whether it was appropriate to include the Commission in the list of
regulators and if so, what types of Commission cease-and-desist orders
should give rise to Rule 506 disqualification. In the proposing
release, we presented possible approaches to including Commission
orders as a disqualifying event and requested comment on those
approaches. We requested comment on whether it would be appropriate to
include cease-and-desist orders issued by the Commission for violations
of the anti-fraud provisions of the federal securities laws, and
whether requiring scienter and including cease-and-desist orders
related to violations of Section 5 of the Securities Act would be
appropriate. Given that Rule 506 offerings provide an exemption from
Section 5 registration, we noted that on that basis, persons who
violate Section 5 should potentially lose the benefit of exemptive
relief for some period afterward.
The request for comment generated a substantial response. Five
comment letters favored covering all Commission orders, including
cease-and-desist orders (subject in some cases to a scienter
requirement).\161\ One comment letter noted that although including
Commission cease-and-desist orders could impair capital formation, the
benefits of doing so would outweigh the risks because adding Commission
orders would more effectively work to screen out bad actors and improve
internal consistency of the rules.\162\ This comment letter described
the proposed rule and the absence of Commission orders as ``under-
inclusive'' because the proposed amendments did not explicitly address
all final orders issued by the Commission addressing fraudulent,
manipulative or deceptive conduct.
---------------------------------------------------------------------------
\161\ See comment letters from Better Markets; Cleary Gottlieb
(scienter required except for Section 5 violations); NYCBA; NASAA;
Whitaker Chalk (scienter required; suggesting that Commission list
the violations that lead to disqualification or adopt a willful
violation standard).
\162\ See comment letter from Cleary Gottlieb.
---------------------------------------------------------------------------
Five comment letters opposed adding Commission cease-and-desist
orders, generally arguing that the Commission lacks authority to expand
on the Section 926 statutory scheme in that way.\163\ One comment
letter suggested the decision to include cease-and-desist orders would
add a large class of regular and routine disciplinary proceedings to
the disqualification provisions, expressing concern that including
administrative cease-and-desist orders that do not require any showing
or finding of intentional misconduct could be viewed as unnecessarily
punitive by disqualifying an organization from particular types of
capital formation activity.\164\ This comment letter also noted that
including cease-and-desist orders marked a departure from the
disciplinary order provisions of Rule 262(b)(3) in which the Commission
has historically interpreted Rule 262 ``to require disqualification
only for as long as some act is prohibited or required to be performed
pursuant to the order.'' \165\ Another comment letter stated that
cease-and-desist orders should not create a disqualification unless it
imposes a limitation or restriction on conduct.\166\ One commenter also
opposed adding Commission cease-and-desist orders based on the
legislative history of Section 15(b)(4)(H) of the Exchange Act, from
which the language used in Section 926 is drawn.\167\
---------------------------------------------------------------------------
\163\ See comment letters from ABA Fed. Reg. Comm.; Five Firms;
Katten Muchin; Rutledge; SIFMA.
\164\ See comment letter from Five Firms.
\165\ Id.
\166\ See comment letter from SIFMA.
\167\ See comment letter from Rutledge.
---------------------------------------------------------------------------
We believe that including certain Commission cease-and-desist
orders in the bad actor disqualification scheme would enhance its
investor protection benefits and make the overall scheme of Rule 506 of
Regulation D more internally consistent. We believe an injunctive or
restraining order issued by a federal court and a Commission cease-and-
desist order arising out of the same legal violation equally
demonstrate disqualifying conduct and should have the same consequences
under our disqualification rules. The benefits associated with
screening bad actors out of the Rule 506 market should not depend on
whether a particular enforcement action is brought in court or through
a Commission cease-and-desist proceeding. For that reason, the final
rules include a provision that makes certain Commission cease-and-
desist orders a disqualifying event.
We disagree with the commenters who argue that the Commission lacks
authority, as part of this rulemaking, to add additional
disqualification triggers not provided in Section 926. In our view,
Section 926 does not limit the existing authority we previously used to
create other bad actor provisions.
In expanding the list of disqualification triggers beyond those
required in Section 926, we are mindful of our mandate to promote
investor protection and capital formation. In particular, we are
mindful of the concerns expressed by commenters about the potentially
negative impact on capital raising of overbroad disqualification
standards.\168\ The concerns associated with including Commission
cease-and-desist orders involved expanding the class of covered persons
subject to disqualification and including administrative cease-and-
desist orders that do not require any showing or finding of scienter.
With those issues in mind, the additional disqualification trigger we
are adopting covers only Commission orders to cease and desist from
violations and future violations of the scienter-based anti-fraud
provisions of the federal securities laws (including, without
limitation, Section 17(a)(1) of the Securities Act,\169\ Section 10(b)
of the Exchange Act \170\ and Rule 10b-5 thereunder,\171\ Section
15(c)(1) of the Exchange Act,\172\ and Section 206(1) of the Advisers
Act \173\) and violations of Section 5 of the Securities Act.\174\ The
additional disqualification trigger for Section 5 violations will not
require scienter, which is consistent with the strict liability
standard imposed by Section 5.\175\ As a policy matter, we do not
believe that exemptions from
[[Page 44745]]
registration based on Rule 506 should be available to persons whose
prior conduct has resulted in an order to cease and desist from
violations of Section 5's registration requirements.
---------------------------------------------------------------------------
\168\ See notes 296-98 and accompanying text.
\169\ 15 U.S.C. 77q(a)(1).
\170\ 15 U.S.C. 78j(b).
\171\ 17 CFR 240.10b-5.
\172\ 15 U.S.C. 78o(c)(1).
\173\ 15 U.S.C. 80b-6(1).
\174\ 15 U.S.C. 77e.
\175\ See SEC v. North American Research and Development Corp.,
424 F.2d 63, 8182 (2d Cir. 1970); Swenson, 626 F.2d at 424 (5th);
SEC v. Ross, 504 F.3d 1130, 1137 (9th Cir. 2007); SEC v. Pearson,
426 F.2d 1339, 1343 (10th Cir. 1970).
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The additional disqualification trigger will be subject to the same
five-year look-back period that applies to court restraining orders and
injunctions,\176\ rather than the 10-year look-back that is mandated to
apply to other regulatory orders under Section 926, which will provide
consistent Commission treatment of cease and desist orders with court
orders.
---------------------------------------------------------------------------
\176\ Rule 506(d)(1)(ii).
---------------------------------------------------------------------------
As adopted, Rule 506(d)(1)(v) imposes disqualification if any
covered person is subject to any order of the Commission entered within
five years before such sale that, at the time of such sale, orders the
person to cease and desist from committing or causing a violation or
future violation of any scienter-based anti-fraud provision of the
federal securities laws (including without limitation Section 17(a)(1)
of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5
thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of
the Advisers Act, or any other rule or regulation thereunder) or
Section 5 of the Securities Act.\177\
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\177\ Rule 506(d)(1)(v).
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6. Suspension or Expulsion From SRO Membership or Association With an
SRO Member
Rule 262(b)(4) disqualifies an offering if any covered person is
suspended or expelled from membership in, or suspended or barred from
association with a member of, a securities self-regulatory organization
or ``SRO'' (i.e., a registered national securities exchange or national
securities association) for any act or omission to act constituting
conduct inconsistent with just and equitable principles of trade.\178\
The proposed rule added a reference to a registered affiliated
securities association and applied the standard to all covered
persons,\179\ but did not otherwise change the substance of the rule.
Under the proposed rule, an offering would be disqualified if any
covered person is suspended or expelled from membership in, or
suspended or barred from association with a member of, a registered
national securities exchange or a registered national or affiliated
securities association for any act or omission to act constituting
conduct inconsistent with just and equitable principles of trade.\180\
---------------------------------------------------------------------------
\178\ See 17 CFR 230.262(b)(4).
\179\ Proposed Rule 506(c)(1)(vi). Rule 262(b)(4) does not apply
to issuers and their predecessors and affiliated issuers. 17 CFR
230.262(b)(4).
\180\ Proposed Rule 501(c)(v).
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The proposal drew little comment,\181\ and we are adopting the text
of the rule as proposed. It is now numbered Rule 506(d)(1)(vi) because
of the addition of the new provision covering certain Commission cease-
and-desist orders in Rule 506(d)(1)(v).
---------------------------------------------------------------------------
\181\ Three commenters responded to our request for comment on
whether commodities exchanges and commodities self-regulatory
organizations should be covered by the provision. One favored such
an extension (comment letter from Better Markets) and two opposed it
(comment letters from Lehman & Eilen, Rutledge). We have not
included such an extension in the final rule.
---------------------------------------------------------------------------
7. Stop Orders and Orders Suspending the Regulation A Exemption
Paragraphs (a)(1) and (2) of Rule 262 impose disqualification on an
offering if the issuer, or any predecessor or affiliated issuer, has
filed a registration statement or Regulation A offering statement that
was the subject of a Commission refusal order, stop order or order
suspending the Regulation A exemption within the last five years, or is
the subject of a pending proceeding to determine whether such an order
should be issued.\182\ Similarly, paragraphs (c)(1) and (2) impose
disqualification if any underwriter of the securities proposed to be
issued was, or was named as, an underwriter of securities under a
registration statement or Regulation A offering statement that was the
subject of a Commission refusal order, stop order or order suspending
the Regulation A exemption within the last five years, or is the
subject of a pending proceeding to determine whether such an order
should be issued.\183\ The proposed rule incorporated the substance of
these four paragraphs in a single paragraph that applied to all covered
persons. Under the proposed rule, an offering would be disqualified if
any covered person has filed (as a registrant or issuer), or was or was
named as an underwriter in, any registration statement or Regulation A
offering statement filed with the Commission that, within five years
before such sale, was the subject of a refusal order, stop order, or
order suspending the Regulation A exemption, or is, at the time of such
sale, the subject of an investigation or proceeding to determine
whether a stop order or suspension order should be issued.\184\
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\182\ 17 CFR 230.262(a)(1) and (2).
\183\ 17 CFR 230.262(c)(1) and (2).
\184\ Proposed Rule 506(c)(1)(vi).
---------------------------------------------------------------------------
The proposal drew only one comment,\185\ which supported the
proposal, and we are adopting the text as proposed, now numbered Rule
506(d)(1)(vii).
---------------------------------------------------------------------------
\185\ See comment letter from Rutledge.
---------------------------------------------------------------------------
8. U.S. Postal Service False Representation Orders
Paragraphs (a)(5) and (b)(5) of Rule 262 impose disqualification on
an offering if the issuer or another covered person is subject to a
U.S. Postal Service false representation order entered within the
preceding five years, or to a temporary restraining order or
preliminary injunction with respect to conduct alleged to have violated
the false representation statute that applies to U.S. mail.\186\ Our
proposed rule incorporated the substance of these paragraphs in a
single paragraph, disqualifying an offering if any covered person is
subject to a United States Postal Service false representation order
entered within five years before such sale, or is, at the time of such
sale, subject to a temporary restraining order or preliminary
injunction with respect to conduct alleged by the United States Postal
Service to constitute a scheme or device for obtaining money or
property through the mail by means of false representations.\187\ The
proposal drew only one comment,\188\ which supported the proposal, and
we are adopting the text as proposed, now numbered Rule
506(d)(1)(viii).
---------------------------------------------------------------------------
\186\ Paragraph (a)(5) relates to issuers and their predecessors
and affiliated issuers, and paragraph (b)(5) relates to other
covered persons. Disqualification results if any covered person ``is
subject to a United States Postal Service false representation order
entered under 39 U.S.C. 3005 within 5 years prior to the filing of
the offering statement, or is subject to a temporary restraining
order or preliminary injunction entered under 39 U.S.C. 3007 with
respect to conduct alleged to have violated 39 U.S.C. 3005.'' 17 CFR
230.262(a)(5) and (b)(5).
\187\ Proposed Rule 506(c)(1)(vii)
\188\ See comment letter from Rutledge.
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D. Reasonable Care Exception
1. Reasonable Care Standard
The proposal included an exception from disqualification for
offerings where the issuer establishes that it did not know and, in the
exercise of reasonable care, could not have known that a
disqualification existed because of the presence or participation of
another covered person.\189\
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\189\ See Proposed Rule 506(c)(2)(ii).
---------------------------------------------------------------------------
The proposal also included an instruction to the reasonable care
exception explaining that an issuer would not be able to establish that
it had exercised reasonable care unless it made a factual inquiry into
whether any disqualifications existed. As proposed, the instruction
noted that the nature and scope of the inquiry would vary based
[[Page 44746]]
on the circumstances of the issuer and the other offering participants.
We proposed the reasonable care exception to preserve the intended
benefits of Rule 506 and avoid creating an undue burden on capital-
raising activities, by reducing the risk that issuers could lose the
benefit of Rule 506 as a result of disqualifications of which they were
unaware.\190\
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\190\ Rule 508 of Regulation D provides that ``insignificant
deviations'' from the terms, conditions and requirements of
Regulation D will not necessarily result in loss of the exemption
from Securities Act registration requirements. Rule 508 provides
that the exemption will not be lost with respect to any offer or
sale to a particular individual or entity as a result of a failure
to comply with a term, condition or requirement of Regulation D if
the person relying on the exemption shows that: the failure to
comply did not pertain to a term, condition or requirement directly
intended to protect that particular individual or entity; the
failure to comply was insignificant with respect to the offering as
a whole (provided that certain Regulation D requirements, including
limitations on general solicitation and any applicable limits on the
amount of securities offered and the number of investors, are always
deemed significant); and a good faith and reasonable attempt was
made to comply. 17 CFR 230.508. We do not believe that Rule 508
would cover circumstances in which an offering was disqualified
based on Rule 506(d).
---------------------------------------------------------------------------
The proposing release did not prescribe or delineate what steps an
issuer would be required to take to show reasonable care. Rather, it
noted that the steps an issuer would take would vary according to the
circumstances of the covered persons and the offering, taking into
account the risk of having a bad actor, the impact of other screening
and compliance mechanisms already in place, and the cost and burden of
the inquiry. We requested comment on the appropriateness of the
reasonable care exception and whether the rule should specify what
factual inquiry is required or provide examples of specific factual
inquiries that would be deemed to constitute reasonable care. The
proposing release also recognized that requiring large issuers or large
financial institutions acting as compensated solicitors to conduct
factual inquiries on potentially lengthy lists of officers could be
burdensome, and therefore we requested comment on whether the rules
should provide specific steps to establish reasonable care in these
circumstances.
In the proposing release, we discussed the reasonable care
exception in the NASAA-approved Model Accredited Investor Exemption
(``MAIE''), which serves as a standard in blue sky law and has been
adopted in some form by a majority of the states. The MAIE requires the
issuer to conduct a ``factual inquiry'' before asserting the reasonable
care exception but does not provide specific information on what steps
are required for the factual inquiry. We also noted in the proposing
release that, as part of the proposed amendments to Regulation D in
2007, the Commission proposed disqualification provisions that included
a reasonable care exception based on the MAIE, without any express
reference to factual inquiry.
The proposed reasonable care exception attempted to address the
potential difficulty for issuers in establishing whether any covered
persons are the subject of disqualifying events, particularly given
that there is no central repository that aggregates information from
all the federal and state courts and regulatory authorities that would
be relevant in determining whether covered persons have a disqualifying
event in their past. We believe such a reasonable care exception will
facilitate the continued utility of Rule 506 in light of the new
disqualification requirements.
Commenters who addressed the issue were unanimous in their support
for a reasonable care exception.\191\ Many, however, voiced concerns
about the perceived vagueness of the proposed exception, and urged us
to provide more guidance on what types of factual inquiry would
constitute compliance.\192\ Some commenters suggested that specific
steps be presumed to establish reasonable care, such as obtaining
questionnaires from appropriate persons (provided the issuer has no
knowledge of undisclosed disqualifying events) \193\ or use of a
reputable background investigations firm.\194\ Another suggested that
issuers be permitted to rely on contractual representations from
registered broker-dealers and other regulated entities, and that
broker-dealers that adopt reasonable policies and procedures to
identify disqualifications in respect of other offering participants
should be presumed to satisfy the ``reasonable care'' test.\195\ One
commenter requested a cut-off date for the determination of bad actor
involvement (e.g., 15 days before commencement of the offering).\196\
Three commenters who supported the reasonable care exception criticized
the proposed factual inquiry requirement, suggesting it would impose
undue burdens on issuers and recommending that we remove it from the
adopted rule.\197\ Another commenter suggested that the Commission look
to the standards that were adopted by NASAA in the Uniform Limited
Offering Exemption and endorsed by NASAA in the Uniform Securities Act,
neither of which contains a factual inquiry component.\198\
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\191\ See, e.g., comment letters from ABA Fed. Reg. Comm.; Angel
Capital Association (July 14, 2011) (``Angel Capital Comment Letter
1''); Better Markets; DTC; Kutak Rock; Lehman & Eilen; NASAA; NYCBA;
Rutledge; SIFMA; Seward & Kissel; S&C; S&W; Whitaker Chalk.
\192\ See, e.g., comment letters from ABA Fed. Reg. Comm.; Kutak
Rock; NYCBA; S&C.
\193\ See Angel Capital Comment Letter 1; see also comment
letter from ABA Fed. Reg. Comm..
\194\ See comment letter from S&W.
\195\ See comment letter from NYCBA; see also comment letters
from ABA Fed. Reg. Comm.; Angel Capital Comment Letter 1; Kutak Rock
(issuers should be able to rely on registered broker-dealer's
confirmation that no disqualification exists).
\196\ See comment letter from Cleary Gottlieb.
\197\ See Angel Capital Comment Letter 1; see also comment
letters from Rutledge; S&C.
\198\ Comment letter from Rutledge. The Uniform Limited Offering
Exemption and the Uniform Securities Act provide exceptions from
disqualification where the issuer shows that it did not know and in
the exercise of reasonable care could not have known that a
disqualification existed.
---------------------------------------------------------------------------
Other commenters stressed the importance of conditioning the
availability of the reasonable care exception on the issuer's factual
inquiry.\199\ These commenters viewed the factual inquiry as a way to
ensure that investor protection is not compromised by issuers' taking
minimal steps designed primarily to satisfy minimum requirements for
the reasonable care standard rather than to ascertain whether
disqualifications actually apply.\200\
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\199\ See comment letters from Better Markets; NASAA.
\200\ E.g., comment letter from Better Markets.
---------------------------------------------------------------------------
We continue to believe that the concept of reasonable care
necessarily includes inquiry by the issuer into the relevant facts, and
we are adopting the provision and its accompanying instruction
substantially as proposed.\201\ There is a wide range of issuers
involved in Rule 506 offerings, from large reporting companies, to
private investment funds, to smaller private companies, all of which
have different legal and ownership structures and may employ a wide
range of financial intermediaries, in terms of size, number of
employees and scope. As a result, we do not believe it is appropriate
to prescribe specific steps as being necessary or sufficient to
establish reasonable care.
---------------------------------------------------------------------------
\201\ See Rule 506(d)(2)(iii) and instruction thereto.
---------------------------------------------------------------------------
Accordingly, as we stated in the proposing release, the steps an
issuer should take to exercise reasonable care will vary according to
the particular facts and circumstances. 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,
[[Page 44747]]
further steps may not be required in connection with a particular
offering. 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.
The timeframe for inquiry should also be reasonable in relation to
the circumstances of the offering and the participants. Consistent with
this standard, the objective should be for the issuer to gather
information that is complete and accurate as of the time of the
relevant transactions, without imposing an unreasonable burden on the
issuer or the other participants in the offering. With that in mind, we
expect that issuers will determine the appropriate dates to make a
factual inquiry, based upon the particular facts and circumstances of
the offering and the participants involved, to determine whether any
covered persons are subject to disqualification before seeking to rely
on the Rule 506 exemption.
In general, issuers should make factual inquiry of the covered
persons, but in some cases--for example, in the case of a registered
broker-dealer acting as placement agent--it may be sufficient to make
inquiry of an entity concerning the relevant set of covered officers
and controlling persons, and to consult publicly available databases
concerning the past disciplinary history of the relevant persons.\202\
Broker-dealers are already required to obtain much of this information
for their own compliance purposes. We anticipate that financial
intermediaries and other market participants will develop procedures
for assisting issuers in gathering the information necessary to satisfy
the issuer's factual inquiry requirement.
---------------------------------------------------------------------------
\202\ FINRA maintains BrokerCheck, an online tool that enables
the public to check the professional backgrounds of current and
former FINRA-registered brokerage firms and brokers, as well as
investment adviser firms and representatives. The information
included in BrokerCheck about brokers and brokerage firms is derived
from the Central Registration Depository, the securities industry
online registration and licensing database. The information about
investment adviser firms and representatives made available through
BrokerCheck is derived from the Commission's Investment Adviser
Public Disclosure (IAPD) database.
---------------------------------------------------------------------------
If the circumstances give an issuer reason to question the veracity
or accuracy of the responses to its inquiries, then reasonable care
would require the issuer to take further steps or undertake additional
inquiry to provide a reasonable level of assurance that no
disqualifications apply.
2. Continuous and Long-Lived Offerings
Some commenters requested specific guidance from the Commission on
factual inquiry procedures for continuous offerings such as those by
hedge funds and some other pooled investment funds.\203\ One commenter
criticized the application of the factual inquiry requirement to
offerings made on a continuous or delayed basis under Rule 506, arguing
that reasonable factual inquiry for all covered persons could be
interpreted to require continuous, real-time monitoring, which would be
especially onerous for issuers in such offerings.\204\ Others suggested
permitting issuers to establish the reasonable care exception solely
through an initial representation about the potential applicability of
disqualifying events followed by subsequent periodic updates, such as
annual negative consent letters relating to any changes to such
representation on a basis consistent with FINRA Rules 5130 and
5131.\205\
---------------------------------------------------------------------------
\203\ See comment letters from Lehman & Eilen; NYCBA; S&C.
\204\ See comment letter from S&C.
\205\ See comment letters from ABA Fed. Reg. Comm.; SIFMA; S&C;
see also comment letter from NYCBA (semi-annual updates). FINRA
Rules 5130 and 5131 permit reliance on written representations for
up to 12 months, with annual negative consent letters thereafter, to
confirm that accounts are not beneficially owned by certain
``restricted persons'' (Rule 5130) or by certain executive officers
and directors or persons materially supported by them (Rule 5131).
---------------------------------------------------------------------------
We believe that for continuous, delayed or long-lived offerings,
reasonable care includes updating the factual inquiry on a reasonable
basis. Again, the frequency and degree of updating will depend on the
circumstances of the issuer, the offering and the participants
involved, but in the absence of facts indicating that closer monitoring
would be required (for example, notice that a covered person is the
subject of a judicial or regulatory proceeding or knowledge of
weaknesses in an organization's screening procedures), we would expect
that periodic updating could be sufficient. We expect that issuers will
manage this through contractual covenants from covered persons to
provide bring-down of representations, questionnaires and
certifications, negative consent letters, periodic re-checking of
public databases, and other steps, depending on the circumstances.
E. Waivers
Consistent with the requirement of Section 926 that the Commission
promulgate disqualification provisions ``substantially similar'' to
Regulation A, the proposal included a waiver provision based on current
Rule 262, under which the Commission could grant a waiver of
disqualification if it determined that the issuer had shown good cause
``that it is not necessary under the circumstances that the
[registration] exemption . . . be denied.'' \206\
---------------------------------------------------------------------------
\206\ Proposed Rule 506(c)(2)(i).
---------------------------------------------------------------------------
The proposing release requested comment on whether the proposed
rule should include a provision such as in the one in the MAIE that
provides an exception from disqualification if the state authority that
issued the disqualifying order waives the disqualification. The
proposing release also requested comment on whether the Commission
should provide guidance as to the circumstances that would likely give
rise to the grant or denial of a waiver and whether the Commission
should exercise waiver authority for cases involving final orders of
state regulators.
1. Waiver for Good Cause Shown
Under current rules, the Commission has delegated authority to
grant disqualification waivers under Regulation A and Rule 505 to the
Director of the Division of Corporation Finance.\207\ Under the
proposal, there would have been no delegation of authority for waivers
of bad actor disqualification under the new Rule 506 disqualification
provisions, and all such waivers would have been issued by a direct
order of the Commission.
---------------------------------------------------------------------------
\207\ See 17 CFR 200.30-1(b), 200.30-1(c).
---------------------------------------------------------------------------
Commenters who addressed the issue were universally supportive of
including a waiver provision in the bad actor disqualification
provisions applicable to Rule 506.\208\ We are adopting the waiver
provision substantially as proposed, with the modifications discussed
below.\209\
---------------------------------------------------------------------------
\208\ See comment letters from ABA Fed. Reg. Comm.; Coy Capital;
DTC; Five Firms; IPA; Katten Muchin; Lehman & Eilen Cotter; I.
Linder (July 14, 2011); MFA; NYCBA; NASAA; REISA; Rutledge; SIFMA;
Seward & Kissel; S&C; Whitaker Chalk.
\209\ See Rule 506(d)(2)(ii).
---------------------------------------------------------------------------
Given the expectation of a short time frame for many Rule 506
offerings, a number of commenters expressed concern over the timeliness
of waiver application reviews by the Commission and the risk that a
lengthy review process may disadvantage issuers seeking speedy access
to capital.\210\ Three commenters urged that authority be delegated to
Commission staff to grant waivers, out of a concern for
[[Page 44748]]
potential delays.\211\ We are sensitive to concerns about delay in the
waiver process, and believe that the staff has managed the process of
granting waivers from Regulation A and Rule 505 disqualification
appropriately in the past. Accordingly, we have determined to clarify
the existing delegation of authority to the Director of the Division of
Corporation Finance by amending it to cover waivers of Rule 506
disqualification.\212\
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\210\ See comment letters from IPA; Seward & Kissel; Whitaker
Chalk.
\211\ See comment letters from ABA Fed. Reg. Comm.; MFA; Seward
& Kissel.
\212\ See 17 CFR 200.30-1(c).
---------------------------------------------------------------------------
Several commenters requested clear guidance on circumstances that
would give rise to the grant of a waiver from disqualification.\213\
Three commenters argued that having clear disqualification waiver
guidelines would result in greater efficiency for market participants
and Commission staff, and encouraged the development of uniform
standards that would prevent unfair application of the disqualification
provisions.\214\ We believe it would be premature to attempt to
articulate standards for granting waivers, although we may consider
doing so after we and the Commission staff have developed experience in
handling waiver requests under the new Rule 506 disqualification rules.
We have, nonetheless, identified in this adopting release a number of
circumstances (such as a change of control, change of supervisory
personnel, absence of notice and opportunity for hearing, and relief
from a permanent bar for a person who does not intend to apply to
reassociate with a regulated entity) that could, depending on the
specific facts, be relevant to the evaluation of a waiver request. This
is not an exhaustive list, and we expect that other factors would also
be relevant to our consideration of waiver requests in particular
cases.
---------------------------------------------------------------------------
\213\ See comment letters from ABA Fed. Reg. Comm.; DTC; Lehman
& Eilen; MFA; Rutledge; Whitaker Chalk.
\214\ See comment letters from ABA Fed. Reg. Comm.; MFA;
Rutledge.
---------------------------------------------------------------------------
2. Waiver Based on Determination of Issuing Authority
In response to our request for comment on how the Commission should
handle waiver applications involving final orders of state regulators,
three commenters recommended that the Commission retain its authority
to waive disqualification arising out of such orders.\215\ One
commenter recommended that waivers should be permitted to be determined
by the state or local authorities or the Commission, at the option of
the issuer.\216\ Several commenters recommended adoption of automatic
exceptions from disqualification similar to those in the MAIE and
Uniform Limited Offering Exemption (``ULOE'').\217\ Under both the MAIE
and ULOE, bad actor disqualification is waived if either (i) the person
against whom an order is issued is licensed or regulated in the
relevant state and is still permitted to conduct securities-related
work in the state, or (ii) the regulator issuing the relevant order
determines that disqualification is not necessary under the
circumstances.\218\ Another commenter recommended that the Commission
not grant a waiver if such a grant would be prejudicial to an action by
the state or regulator.\219\
---------------------------------------------------------------------------
\215\ See comment letters from ABA Fed. Reg. Comm.; Coy Capital;
NYCBA.
\216\ See comment letter from REISA.
\217\ See comment letters from ABA Fed. Reg. Comm.; Five Firms;
IPA; I. Linder; Rutledge; SIFMA; Whitaker Chalk; see also comment
letter from NYCBA. The Uniform Limited Offering Exemption was
adopted by NASAA in 1983 and again in 1989. It is designed to
provide a state-level exemption for offerings that are exempt from
registration at the federal level under Rule 505 of Regulation D.
Peter M. Fass and Derek A. Wittner, Blue Sky Practice for Public and
Private Direct Participation Offerings, Sec. 9.19 and Appendix 9A
(Thomson Reuters/West 2008).
\218\ See MAIE paragraphs (D)(2)(a)-(b) (available at http://www.nasaa.org/wp-content/uploads/2011/07/24-Model_Accredited_Investor_Exemption.pdf) and Fass and Wittner, note 205, at Appendix
9A, paragraph B.6.
\219\ See comment letter from NASAA.
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We are persuaded that the second leg of the MAIE/ULOE exception to
disqualification, under which disqualification does not apply if the
regulator issuing the relevant order determines that Rule 506
disqualification is not necessary under the circumstances, strikes an
appropriate balance. It allows the relevant authorities to determine
the impact of their orders and conserves Commission resources (which
might otherwise be devoted to consideration of waiver applications) in
cases where the relevant authority determines that disqualification
from Rule 506 offerings is not warranted. Accordingly, the final rule
contains a provision based on MAIE paragraph (D)(2)(b), under which
disqualification will not arise if, before the relevant sale is made in
reliance on Rule 506, the court or regulatory authority that entered
the relevant order, judgment or decree advises in writing, whether in
the relevant judgment, order or decree or separately to the Commission
or its staff, that disqualification under Rule 506 should not arise as
a consequence of such order, judgment or decree.\220\ Because
disqualification will not arise in those circumstances, no waiver need
be sought from the Commission for a person subject to such an order,
judgment or decree to participate in a Rule 506 offering. Even in the
absence of such advice, however, the Commission may still exercise its
discretion to grant waivers under Rule 506(d)(2)(ii) in cases where it
considers it appropriate to do so.\221\
---------------------------------------------------------------------------
\220\ See Rule 506(d)(2).
\221\ Conversely, in cases where disqualification does not arise
on the basis of an order, judgment or decree because the issuing
authority advises that it should not, the Commission would not be
precluded from pursuing its own enforcement action, which may result
in a court order or judgment or a Commission order that constitutes
an independent basis for disqualification.
---------------------------------------------------------------------------
We are not, however, including a provision based on the first leg
of the MAIE/ULOE test, which prevents disqualification if the
triggering event occurs with respect to a regulated person, such as a
broker-dealer, and such person continues to be licensed or registered
to conduct securities-related business in the relevant state. As a
practical matter, this approach eliminates from the MAIE/ULOE
disqualification scheme all orders that are not bars or revocation of
registration or licensure. We believe such an approach would be
incompatible with the language of Section 926, which, by its terms,
covers both bars and other final orders. For that reason, we have not
adopted it. We may, however, take the fact that registration or
licensure has not been suspended or revoked into account when
considering waiver applications.
F. Transition Issues
1. Disqualification Applies Only to Triggering Events That Occur After
Effectiveness of the Rule Amendments
Under the proposal, the new disqualification provisions would have
applied to all sales made under Rule 506 after the effective date of
the rule amendments. Offerings made after the effective date would have
been subject to disqualification for all disqualifying events that
occurred within the relevant look-back periods, regardless of whether
the events occurred before enactment of the Dodd-Frank Act, or the
proposal or effectiveness of the amendments to Rule 506.
We requested comment on this approach, both in broad terms and as
to specific aspects, such as whether we should make special provision
for orders issued in the context of negotiated settlements and whether
we should provide for extensions of waivers granted with respect to bad
actor disqualification under Regulation A, Rule 505 of Regulation D or
[[Page 44749]]
Regulation E, so they would apply to Rule 506 disqualification as well.
This section of the proposing release drew more comment than any other.
Five commenters supported including prior bad actor disqualifying
events in the disqualification provisions, generally arguing, on
investor protection grounds, that the purpose of the rule is to prevent
all bad actors from participating in Rule 506 offerings.\222\ For
example, one such commenter asserted, ``[a]s between issuers and
investors, it is far preferable that issuers face the delays or
inconvenience necessary to cure disqualifications or register their
offerings than for investors to be victimized by an issuer or promoter
that was demonstrably unfit to invoke the Rule 506 exemption.'' \223\
One commenter argued that contested proceedings should not be
grandfathered because in those cases the respondent had no choice in
the ultimate result of the proceeding.\224\
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\222\ See comment letters from Anonymous (July 12, 2011); Better
Markets; J. Davis (June 13, 2011); DTC; NASAA.
\223\ See comment letter from Better Markets.
\224\ See comment letter from Lehman & Eilen.
---------------------------------------------------------------------------
On the other hand, 15 comment letters requested that the Commission
not apply the rules to past triggering events, or else provide for
widespread grandfathering.\225\ Critics of applying the rules to past
events objected on the basis of statutory construction,\226\ the
Supreme Court decision in Landgraf v. USI Film Products,\227\ and
Congressional intent.\228\ Many commenters also argued that such
application of the new disqualification rules would unfairly upset
previously negotiated civil and administrative settlements, or impose
an unforeseeable new sanction in respect of prior conduct.\229\ Several
commenters recommended providing automatic waivers for settlements, or
automatic extension of existing Regulation A and Rule 505 waivers if
the new rules were to be applied to pre-existing events.\230\ Another
commenter argued that prospective application of disqualification
provisions would be consistent with the Commission's approach to
analogous bad actor disqualification provisions in the past, such as
the ``ineligible issuer'' provisions of the Securities Offering Reform
rule adopted in 2005 and the disqualification provisions adopted under
the Private Securities Litigation Reform Act of 1995.\231\
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\225\ See comment letters from Alfaro; ABA Fed. Reg. Comm.;
Cleary Gottlieb; Coy Capital; Five Firms; IPA; Katten Muchin; Munck
Carter; NYCBA; REISA; Rutledge; Seward & Kissel; SIFMA; S&C;
Whitaker Chalk.
\226\ See comment letters from ABA Fed. Reg. Comm.; Coy Capital;
Five Firms; MFA; NYCBA; S&C.
\227\ See comment letters from ABA Fed. Reg. Comm.; Coy Capital;
Five Firms.
\228\ See comment letters from Five Firms; MFA.
\229\ See comment letters from ABA Fed. Reg. Comm.; Coy Capital;
IPA; Lehman & Eilen; MFA; Munck Carter; REISA; Rutledge; SIFMA;
Whitaker Chalk.
\230\ See comment letters from ABA Fed. Reg. Comm.; Cleary
Gottlieb; Five Firms; Rutledge; S&C.
\231\ See comment letter from ABA Fed. Reg. Comm.
---------------------------------------------------------------------------
In light of the views expressed by commenters, including concerns
about potential unfairness, we have determined not to trigger Rule 506
disqualification on the basis of preexisting events. Accordingly, the
amendments we are adopting today include a provision specifying that
disqualification will not arise as a result of triggering events that
occurred before the effective date of the rule amendments.\232\ We
will, however, require disclosure to investors regarding such events.
---------------------------------------------------------------------------
\232\ See Rule 506(d)(2)(i). The rule looks to the timing of the
triggering event (e.g., a criminal conviction or court or regulatory
order) and not the timing of the underlying conduct. A triggering
event that occurs after effectiveness of the rule amendments will
result in disqualification, even if the underlying conduct occurred
before effectiveness.
---------------------------------------------------------------------------
2. Mandatory Disclosure of Triggering Events That Pre-Date
Effectiveness of the Rule Amendments
In the proposing release, we solicited comment on whether we should
require disclosure, rather than disqualification, for bad actor
triggering events that occurred before the effective date of the new
rules. Several commenters were supportive.\233\ One commenter viewed
the disclosure requirement favorably as a way to balance fairness to
issuers and other covered persons with the need for investor protection
without impairing the effectiveness of the rule.\234\ This commenter
noted that any negative impact associated with applying
disqualification only to events occurring after the effective date of
the rule amendments would be ameliorated by requiring disclosure to
investors of the existence of the event. Another commenter viewed
disclosure as an appropriate method of dealing with past orders or
convictions rather than imposing automatic disqualification since
issuers would be unable to revisit the disqualifying conduct and alter
the collateral consequences of those past convictions and orders as a
result of the new disqualifying provisions.\235\ In addition, one
commenter argued more generally that the disqualification rules should
be broadly reconsidered and a disclosure-based approach adopted
instead.\236\
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\233\ See comment letters from Lehman & Eilen; Munck Carter;
REISA.
\234\ See comment letter from Munck Carter.
\235\ See comment letter from REISA.
\236\ See comment letter from ABA Fed. Reg. Comm.
---------------------------------------------------------------------------
In lieu of imposing disqualification for pre-existing triggering
events, the rule amendments require written disclosure of matters that
would have triggered disqualification, except that they occurred before
the effective date of the new disqualification provisions.\237\ In
light of Congress' concerns about the participation of certain felons
and other bad actors in Rule 506 offerings, we believe this disclosure
is important to put investors on notice of bad actor involvement in
Rule 506 offerings that they are evaluating as potential investments.
We believe this is particularly important after adoption of the new bad
actor disqualification requirements for Rule 506 offerings because, as
a result of the adoption of the new requirements implementing Section
926, investors may have the impression that all bad actors are now
disqualified from participation in Rule 506 offerings. We expect that
issuers will give reasonable prominence to the disclosure to ensure
that information about pre-existing bad actor events is appropriately
presented in the total mix of information available to investors.
---------------------------------------------------------------------------
\237\ See Rule 506(e).
---------------------------------------------------------------------------
The disclosure requirement in new Rule 506(e) will apply to all
offerings under Rule 506, regardless of whether purchasers are
accredited investors. Issuers will be required to provide disclosure
``a reasonable time prior to sale,'' which is the same timing that
currently applies to disclosures to non-accredited investors under Rule
502(b)(1).\238\
---------------------------------------------------------------------------
\238\ 17 CFR 230.502(b)(1).
---------------------------------------------------------------------------
If disclosure is required and not adequately provided to an
investor, we do not believe that relief will be available under Rule
508, under which ``insignificant deviations'' from Regulation D
requirements do not necessarily result in loss of the Securities Act
exemption with regard to an offer or sale of securities to a particular
individual or entity.\239\ For Rule 508 to apply to an offer or sale of
securities, the failure to comply with a Regulation D requirement must
not pertain to a term, condition or requirement directly intended to
protect that offeree or purchaser.\240\ Disclosure of pre-existing
triggering events under
[[Page 44750]]
new Rule 506(e) is intended to benefit all investors by alerting them
to any bad actors associated with the issuer or the offering, and,
therefore, this condition of Rule 508 cannot be met where the required
disclosure is not provided.
---------------------------------------------------------------------------
\239\ See note 190.
\240\ See 17 CFR 230.508(a)(1).
---------------------------------------------------------------------------
Rule 506(e) does, however, provide that the failure to furnish
required disclosure on a timely basis will not prevent an issuer from
relying on Rule 506 if the issuer establishes that it did not know, and
in the exercise of reasonable care could not have known, of the
existence of the undisclosed matter or matters. This ``reasonable
care'' exception to the disclosure requirement is similar to the
``reasonable care'' exception to disqualification we are also adopting
today, and will preserve an issuer's claim to reliance on Rule 506 if
disclosure is required but the issuer can establish that it did not
know and in the exercise of reasonable care could not have known of the
matters required to be disclosed. The provision also includes an
instruction, similar to the instruction to Rule 506(d)(2)(iv),
clarifying that reasonable care requires factual inquiry.
3. Timing of Implementation
Under our proposal, the new bad actor disqualification rules would
have been implemented without any deferral period. We solicited comment
on whether deferral would be appropriate. While two commenters opposed
any delayed implementation, citing investor protection concerns,\241\
several others urged us to implement the rules on a delayed basis to
permit issuers to put compliance procedures in place and allow time for
obtaining any necessary waivers.\242\
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\241\ See comment letters from DTC; NASAA.
\242\ See, e.g., comment letters from ABA Fed. Reg. Comm.; Five
Firms; Kutak Rock; NYCBA; SIFMA.
---------------------------------------------------------------------------
As adopted, the bad actor disqualification provisions of Rule
506(d) will take effect 60 days after publication in the Federal
Register, without any additional deferral period. We concluded that an
additional deferral is not necessary or appropriate since
disqualification will not be imposed in respect of pre-existing
triggering events so, although issuers and other offering participants
will need to make reasonable factual inquiries during this 60-day
period, no additional time is needed for waivers to be sought in
respect of such events. Accordingly, the new disqualification
provisions of Rule 506(d) and the mandatory disclosure provision of
Rule 506(e) will apply to each sale of securities made in reliance on
Rule 506 after the rule amendments go into effect.
As we discussed in the proposing release, sales of securities made
before the applicable effective dates will not be affected by any
disqualification or disclosure requirement, even if such sales are part
of an offering that continues after the relevant effective date. Only
sales made after the effective date of the amendments will be subject
to disqualification and mandatory disclosure.
Disqualifying events that occur while an offering is underway will
be treated in a similar fashion. Sales made before the occurrence of
the disqualification trigger will not be affected by it, but sales made
afterward will not be entitled to rely on Rule 506 unless the
disqualification is waived or removed, or, if the issuer is not aware
of a triggering event, the issuer can rely on the reasonable care
exception.\243\
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\243\ Disqualifying events that exist at the time the offering
is commenced but are only discovered later will be disqualifying,
and the sales will not be eligible for reliance on Rule 506, subject
to the application of the reasonable care exception.
---------------------------------------------------------------------------
This approach is consistent with our other rules and we believe
provides appropriate incentives to issuers and other covered persons.
We solicited comment on other possible approaches, including not
applying the new rules to offerings that are underway at the time of
effectiveness of the new disqualification provisions. Several
commenters supported complete or partial grandfathering for offerings
that are underway at the time of effectiveness.\244\ We do not think
such grandfathering would be necessary, given that pre-existing events
will give rise only to a disclosure requirement and not to
disqualification. Further, some ongoing offerings could continue for
years after the rule amendments take effect. We do not believe it would
be appropriate to implement Section 926 in a way that would exempt such
offerings on a long-term basis. Issuers should be able to make
reasonable factual inquiries and prepare any necessary disclosures
during the 60 days before the rules become effective.
---------------------------------------------------------------------------
\244\ See comment letters from Katten Muchin; Whitaker Chalk;
Coy Capital; Rutledge.
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G. Amendment to Form D
We are adopting as proposed the conforming amendment to Form D.
Under the amendment, the signature block of the Form D will contain a
certification, similar to the current certification by Rule 505
issuers, whereby issuers claiming a Rule 506 exemption will confirm
that the offering is not disqualified from reliance on Rule 506 for one
of the reasons stated in Rule 506(d).
III. Paperwork Reduction Act
A. Background
The mandatory disclosure provisions required under the final rules
contain ``collection of information'' requirements within the meaning
of the Paperwork Reduction Act of 1995 (``PRA'').\245\ The title for
the collection of information is:
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\245\ 44 U.S.C. 3501 et seq.
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``Regulation D Rule 506(e) Felons and Other Bad Actors
Disclosure Statement.'' We are requesting comment on the collection of
information requirements in this adopting release, and are submitting
these requirements to the Office of Management and Budget (``OMB'') for
review in accordance with the PRA and its implementing
regulations.\246\ We are applying for an OMB control number for the
proposed new collection of information in accordance with 44 U.S.C.
3507(j) and 5 CFR 1320.13, and OMB has not yet assigned a control
number to the new collection. Responses to the new collection of
information would be mandatory. An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a currently valid OMB control number.
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\246\ In the proposing release, we did not submit a PRA analysis
because we did not propose mandatory disclosure of past
disqualifying events. At this time, we do not have any comments
regarding overall burden estimates for the rule amendments. This
release is requesting such comments.
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As adopted, the amendments to Rule 506 require that the issuer
furnish to each purchaser, a reasonable time prior to sale, a written
description of any matters that occurred before effectiveness of the
final amendments and within the time periods described in the list of
disqualification events set forth in Rule 506(d)(1) of Regulation D, in
regard to the issuer or any other ``covered person'' associated with
the offering. For purposes of the mandatory disclosure provision of
Rule 506(e), issuers will be required to ascertain whether any
disclosures are required in respect of covered persons involved in
their offerings, prepare any required disclosures and furnish them to
purchasers.
The Commission adopted the Regulation D Rule 506(e) Felons and
Other Bad Actors Disclosure Statement under the Securities Act. The
Regulation D Rule 506(e) Felons and Other Bad Actors Disclosure
Statement required to be furnished to investors does not involve
submission of a form
[[Page 44751]]
filed with the Commission and is not required to be presented in any
particular format, although it must be in writing. The hours and costs
associated with preparing and furnishing the Regulation D Rule 506(e)
Felons and Other Bad Actors Disclosure Statement to investors in the
offering constitute reporting and cost burdens imposed by the
collection of information. An agency may not conduct or sponsor, and a
person is not required to respond to, a collection of information
unless it displays a currently valid OMB control number.
The disclosure or paperwork burden imposed on issuers appears in
Rule 506(e) and pertains to events that occurred before effectiveness
of the final rules but which would have triggered disqualification had
they occurred after effectiveness. Issuers relying on Rule 506 must
furnish disclosure of any relevant past events listed in Rule 506(e)
that relate to the issuer or any other covered person. If there are any
such events, a disclosure statement is required to be furnished, a
reasonable time before sale, to all purchasers in the offering. The
disclosure requirement serves to protect purchasers by ensuring that
they receive information regarding any covered persons that were
subject to such disqualifying events.
The disclosure requirement does not apply to triggering events
occurring after the effective date of the rule amendments adopted
today, because those events will result in disqualification from
reliance on Rule 506 (absent a waiver or other exception provided in
Rule 506(d)), rather than any disclosure obligation.
The steps that issuers will take to comply with the disclosure
requirement are expected to mirror the steps they take to determine
whether they are disqualified from relying on Rule 506. We expect that
issuers planning or conducting a Rule 506 offering will undertake a
factual inquiry to determine whether they are subject to any
disqualification. Disqualification and mandatory disclosure are
triggered by the same types of events in respect of the same covered
persons, with disqualification arising from triggering events occurring
after these rules take effect and mandatory disclosure applicable to
events occurring before that date. Therefore, we expect that factual
inquiry into potential disqualification can simply be extended to cover
the period before the rules become effective. On that basis, we expect
that the factual inquiry process for the disclosure statement
requirement will impose a limited incremental burden on issuers.
As stated earlier, we expect that the size of the issuer and the
circumstances of the particular Rule 506 offering will determine the
scope of the factual inquiry and require tailored and offering-specific
data gathering approaches. It should not generally be necessary for any
issuer or any compensated solicitor to make inquiry of any covered
individual with respect to ascertaining the existence of events that
require disclosure more than once, because the period to be covered by
the inquiry ends with the effective date of the new disqualification
rules (so future events are unlikely to affect the inquiry or change
the disclosures that have to be made). We do, however, expect that
issuers may be required to revise their factual inquiry for each Rule
506 offering due to changes in management or intermediaries, other
changes to the group of covered persons or if questions arise about the
accuracy of previous responses. We also expect that the disclosure
requirement may serve the additional function of helping issuers
develop processes and procedures for the factual inquiry required to
establish reasonable care under the disqualification provisions of Rule
506(d), which will be effective prospectively.
B. Burden and Cost Estimates Related to the Adopted Amendments
We anticipate that the disclosure requirement will result in an
incremental increase in the burdens and costs for issuers that rely on
the Rule 506 exemption by requiring these issuers to conduct factual
inquiries into the backgrounds of covered persons with regard to events
that occurred before effectiveness of the final bad actor
disqualification rules. For purposes of the PRA, we estimate the total
annual increase in paperwork burden for all affected Rule 506 issuers
to comply with our proposed collection of information requirements to
be approximately 22,108 hours of company personnel time and
approximately $264,000 for the services of outside professionals. These
estimates include the incremental time and cost of conducting a factual
inquiry to determine whether the Rule 506 issuers have any covered
persons with past disqualifying events. The estimates also include the
cost of preparing a disclosure statement that issuers are required to
furnish to each purchaser a reasonable time prior to sale.\247\
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\247\ 17 CFR 230.502(b)(2)(iii).
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In deriving our estimates, we assume that:
Approximately 19,908 Rule 506 issuers \248\ relying on
Rule 506 of Regulation D will spend on average one additional hour to
conduct a factual inquiry to determine whether any covered persons had
a disqualifying event that occurred before the effective date of the
rule amendments; and
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\248\ Filing data reviewed by the staff of the Commission's
Division of Economic and Risk Analysis indicate that for 2012,
15,028 issuers claiming the Rule 506 exemption filed one Form D and
1,250 such issuers filed more than one Form D. For purposes of the
PRA estimates, we assume that all initial filers and approximately
one quarter of repeat filers will conduct a factual inquiry, with
the remaining repeat filers relying on prior factual inquiries.
There is evidence that some issuers are not filing Form D for their
offerings in compliance with Rule 503 as discussed in Part IX.B.4.a.
of Amendments to Regulation D, Form D and Rule 156 under the
Securities Act, Proposing Release No. 33-9416, (July 10, 2013). In
addition, we estimate that the amendments to Rule 506(c) adopted
today will result in a 20% increase in Form D filings relying on the
Rule 506(c) exemption. See Eliminating the Prohibition Against
General Solicitation and General Advertising in Rule 506 and Rule
144A Offerings, Adopting Release No. 33-9415, Part V.B. (July 10,
2013). For purposes of our PRA estimates, we have assumed that the
estimated 20% increase in the number of Form D filings corresponds
to a 20% increase in the number of issuers that will need to conduct
a factual inquiry to determine whether a disclosure statement is
necessary.
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On the basis of the factual inquiry, approximately 220
\249\ Rule 506 issuers will spend ten hours to prepare a disclosure
statement describing matters that would have triggered disqualification
under Rule 506(d)(1) of Regulation D had they occurred on or after the
effective date of the rule amendments; and
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\249\ Staff estimates that there were at least 549 SEC
enforcement cases involving an unregistered offering in which
someone who would be disqualified as a bad actor participated in the
five years from 2007 through 2011, see Part IV.B.3, or at least 110
such offerings per year. This is a lower bound estimate based on a
review of triggering events arising from Commission action only, and
not other triggering events such as criminal convictions and state
regulatory action. For purposes of the Paperwork Reduction Act
analysis, we are doubling the number of Rule 506 offerings estimated
to involve a bad actor, to account for such other triggering events.
We are not aware of any database that would allow us to estimate
with precision the number of other triggering events or the number
of additional bad actors associated with them. Some data on state
enforcement actions indicate that there would be a substantial
number of other triggering events (see, e.g., NASAA's 2012
Enforcement Report, discussed at text accompanying note 283);
however, the data do not allow us to determine how many state
enforcement actions are unique, as more than one state may take
regulatory action against the same person and some state actions may
overlap with Commission actions.
---------------------------------------------------------------------------
For purposes of the disclosure statement, 220 Rule 506
issuers will retain outside professional firms to spend three hours on
disclosure preparation at an average cost of $400 per hour.
The increase in burdens and costs associated with conducting the
factual
[[Page 44752]]
inquiry for the disclosure statement requirement should pose a minimal
incremental effort given that issuers are simultaneously required to
conduct a similar factual inquiry for purposes of determining
disqualification from the Rule 506 exemption.
It is difficult to provide any standardized estimates of the costs
involved with the factual inquiry. There is no central repository that
aggregates information from all federal and state courts and regulators
that would be relevant in determining whether a covered person has a
disqualifying event in his or her past. In this regard, we are
currently unable to accurately estimate the burdens and costs for
issuers in a verifiable way. We expect, however, that the costs to
issuers may be higher or lower depending on the size of the issuer and
the number and roles of covered persons. We realize there may be a wide
range of issuer size, management structure, and offering participants
involved in Rule 506 offerings and that different issuers may develop a
variety of different factual inquiry procedures.
Where the issuer or any covered person is subject to an event
listed in Rule 506(e) existing before the effective date of these
rules, the issuer will be required to prepare disclosure for each
relevant Rule 506 offering. The estimates include the time and the cost
of data gathering systems, the time and cost of preparing and reviewing
disclosure by in-house and outside counsel and executive officers, and
the time and cost of delivering or furnishing documents and retaining
records.
Issuers conducting ongoing or continuous offerings will be required
to update their factual inquiry and disclosure as necessary to address
additional covered persons. The annual incremental paperwork burden,
therefore, depends on an issuer's Rule 506 offering activity and the
changes in covered persons from offering to offering. For example, some
issuers may only conduct one Rule 506 offering during a year while
other issuers may have multiple, separate Rule 506 offerings during the
course of the same year involving different financial intermediaries,
may hire new executive officers or may have new 20% shareholders, any
of which will result in a different group of covered persons. In
deriving our estimates, we recognize that the burdens will likely vary
among individual companies based on a number of factors, including the
size and complexity of their organizations. We believe that some
companies will experience costs in excess of this estimated average and
some companies may experience less than the estimated average costs.
Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), we request comment to:
Evaluate whether the proposed collections of information
are necessary for the proper performance of the functions of the
Commission, including whether the information will have practical
utility;
Evaluate the accuracy of our estimate of the burden of the
proposed collections of information;
Determine whether there are ways to enhance the quality,
utility, and clarity of the information to be collected;
Evaluate whether there are ways to minimize the burden of
the collections of information on those who respond, including through
the use of automated collection techniques or other forms of
information technology; and
Evaluate whether the proposed amendments will have any
effects on any other collections of information not previously
identified in this section.
Any member of the public may direct to us any comments concerning
the accuracy of these burden estimates and any suggestions for reducing
the burdens. Persons who wish to submit comments on the collection of
information requirements should direct their comments to OMB,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Room 10102, New Executive
Office Building, Washington, DC 20503 and should send a copy to
Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100
F Street NE., Washington, DC 20549-1090, with reference to File No. S7-
31-10. Requests for materials submitted to the OMB by us with regard to
these collections of information should be in writing, refer to File
No. S7-31-10 and be submitted to the Securities and Exchange
Commission, Office of Investor Education and Advocacy, 100 F Street
NE., Washington, DC 20549-0213. Because OMB is required to make a
decision concerning the collections of information between 30 and 60
days after publication, your comments are best assured of having their
full effect if OMB receives them within 30 days of publication.
IV. Economic Analysis
A. Background and Summary of the Rule Amendments
As discussed above, we are adopting amendments to implement the
requirements of Section 926 of the Dodd-Frank Act, relating to the
disqualification of ``felons and other `bad actors' '' from
participation in Rule 506 offerings. Section 926 of the Dodd-Frank Act
requires the Commission to issue rules that disqualify issuers making
securities offerings involving felons and other bad actors from relying
on Rule 506 of Regulation D. These rules are required to be
``substantially similar'' to the disqualification rules in Rule 262
(which apply to Regulation A offerings as well as offerings under Rule
505 of Regulation D) and also to cover the matters enumerated in
Section 926 (including certain state regulatory orders and bars). We
believe the rules we are adopting comply with that mandate. The final
rules include the following provisions not specifically required under
Section 926:
A reasonable care exception;
Mandatory disclosure of triggering events pre-dating the
effective date of the rule amendments;
The inclusion of additional triggering events for certain
orders of the CFTC and for Commission cease-and-desist orders relating
to scienter-based anti-fraud violations and violations of Section 5 of
the Securities Act;
The addition of coverage of investment managers of pooled
investment funds and directors, executive officers, other officers
participating in the offering, general partners and managing members of
such investment managers and directors, executive officers and other
officers participating in the offering of such general partners and
managing members;
Narrower coverage of officers of issuers and financial
intermediaries (covering only executive officers and officers
participating in the offering, rather than all officers);
Narrower coverage of shareholders of the issuer (covering
only beneficial owners of at least 20% of the issuer's outstanding
voting securities, calculated on the basis of voting power, rather than
10% of any class of the issuer's equity securities); and
A provision under which disqualification will not be
triggered by regulatory orders if the authority that issued the order
advises in writing that Rule 506 disqualification should not arise.
While commenters had differing views on whether disqualification
under Rule 506 could or should be applied to events that occurred
before the effective date of the rule amendments, we determined to
apply disqualification only to events that occur after effectiveness of
the rule amendments.
[[Page 44753]]
As noted above, we are requiring disclosure of disqualifying events
that pre-date effectiveness of the amendments.
We are sensitive to the costs and benefits imposed by our rules.
The discussion below attempts to address both the costs and benefits of
Section 926 of the Dodd-Frank Act itself, as well as the incremental
costs and benefits of the rules and rule amendments associated with the
exercise of our discretion in implementing Section 926. The costs and
benefits attributable to the statutory mandate and those attributable
to our discretion may not be entirely separable to the extent that our
discretion is exercised to realize the benefits that we believe were
intended by the Dodd-Frank Act.
Section 2(b) of the Securities Act \250\ requires us, when engaging
in rulemaking where we are required to consider or determine whether an
action is necessary or appropriate in the public interest, to consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. We have
considered those issues as part of this economic analysis.
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\250\ 15 U.S.C. 77b(b).
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B. Economic Baseline
The baseline analysis that follows is in large part based on
information collected from Form D filings submitted by issuers relying
on Regulation D to raise capital. As we describe in more detail below,
we believe that we do not have a complete view of the Rule 506 market,
particularly with respect to the amount of capital raised. Currently,
issuers are required to file a Form D within 15 days of the first sale
of securities, and are required to report additional sales through
amended filings only under certain conditions. In addition, issuers may
not report all required information, either due to error or because
they do not wish to make the information public. Commenters have
suggested and we also have evidence that some issuers do not file a
Form D for their offerings in compliance with Rule 503.\251\
Consequently, the analysis that follows is necessarily subject to these
limitations in the current Form D reporting process.
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\251\ Many commenters asserted that non-compliance with Form D
filing obligations is widespread. See, e.g., letters from Investor
Advisory Committee (stating that ``[i]t is generally acknowledged
that a significant number of issuers do not currently file Form D. .
.''); AARP (stating that ``[s]imply adding a checkbox to a form that
too often goes unfiled and then only after the fact is inadequate to
the task at hand.''); AFL-CIO and AFR (stating that ``many issuers
today flout the Form D filing requirement for such offerings,
further limiting the Commission's ability to provide effective
oversight''). See also Securities and Exchange Commission, Office of
Inspector General, Regulation D Exemption Process (Mar. 31, 2009)
(``OIG Report''), available at: http://www.sec-oig.gov/Reports/AuditsInspections/2009/459.pdf (stating that while the Commission
staff ``strongly encourage companies to comply with Rule 503, they
are aware of instances in which issuers have failed to comply with
Rule 503 . . .''). Based on its analysis of the filings required by
FINRA Rules 5122 and 5123 during the period of December 3, 2012 to
February 5, 2013, DERA estimates that as many as 9% of the offerings
represented in the FINRA filings for Regulation D or other private
offerings that used a registered broker did not have a corresponding
Form D.
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1. Size of the Exempt Offering Market
Exempt offerings play a significant role in capital formation in
the United States. Offerings conducted in reliance on Rule 506 account
for 99% of the capital reported as being raised under Regulation D from
2009 to 2012, and represent approximately 94% of the number of
Regulation D offerings.\252\ The significance of Rule 506 offerings is
underscored by the comparison to registered offerings. In 2012, the
estimated amount of capital reported as being raised in Rule 506
offerings (including both equity and debt) was $898 billion, compared
to $1.2 trillion raised in registered offerings.\253\ Of this $898
billion, operating companies (issuers that are not pooled investment
funds) reported raising $173 billion, while pooled investment funds
reported raising $725 billion.\254\ The amount reported as being raised
by pooled investment funds is comparable to the amount of capital
raised by registered investment funds. In 2012, registered investment
funds (which include money market mutual funds, long-term mutual funds,
exchange-traded funds, closed-end funds and unit investment trusts)
raised approximately $727 billion.\255\
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\252\ See Vladimir Ivanov and Scott Bauguess, Capital Raising in
the U.S.: An Analysis of Unregistered Offerings Using the Regulation
D Exemption, 2009-2012 (July 2013), available at http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf
(``Ivanov/Bauguess Study'').
\253\ See id.
\254\ See id.
\255\ In calculating the amount of capital raised by registered
investment funds, we use the net amounts (plus reinvested dividends
and reinvested capital gains), which reflect redemptions, and not
gross amounts, by open-ended registered investment funds because
they face frequent redemptions, and do not have redemption
restrictions and lock-up periods common among private funds. In
addition, we use the new issuances of registered closed-end funds
and the new deposits of registered unit investment trusts. See 2013
Investment Company Institute Factbook, available at http://www.icifactbook.org.
---------------------------------------------------------------------------
In 2011, the estimated amount of capital (including both equity and
debt) reported as being raised in Rule 506 offerings was $849 billion
compared to $985 billion raised in registered offerings.\256\ Of the
$849 billion, operating companies reported raising $71 billion, while
pooled investment funds reported raising $778 billion.\257\ More
generally, when including offerings pursuant to other exemptions--Rule
144A, Regulation S and Section 4(a)(2)--significantly more capital
appears to be raised through exempt offerings than registered offerings
(Figure 1).\258\
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\256\ See Ivanov/Bauguess Study.
\257\ See id.
\258\ See id.
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[[Page 44754]]
[GRAPHIC] [TIFF OMITTED] TR24JY13.005
At present, issuers are required to file a Form D not later than
15 days after the first sale of securities in a Regulation D offering
and an amendment to the Form D only under certain circumstances. Since
issuers are not required to submit a filing when an offering is
completed, and submit amendments only under certain circumstances, we
have no definitive information on the final amounts raised. Figure 2,
below, illustrates that at the time of the initial Form D filing, only
39% of offerings by non-pooled investment fund issuers were completed
relative to the total amount sought. Separately, 70% of pooled
investment funds state their total offering amount to be ``Indefinite''
in their Form D filings. As a result, the initial Form D filings of
these pooled investment funds likely do not accurately reflect the
total amount of securities offered or sold.
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\259\ The 2012 non-ABS Rule 144A offerings data is based on an
extrapolation of currently available data through May 2012 from
Sagient Research System's Placement Tracker database. For more
detail, see the Ivanov/Bauguess Study.
[GRAPHIC] [TIFF OMITTED] TR24JY13.006
2. Affected Market Participants
The amendments to Rule 506 we are adopting today will affect a
number of different market participants. Issuers of securities in Rule
506 offerings include both reporting and non-reporting operating
companies and pooled investment funds. Investment advisers organize and
sponsor pooled investment
[[Page 44755]]
funds that conduct Rule 506 offerings. Intermediaries that facilitate
Rule 506 offerings include registered broker-dealers, finders and
placement agents. Investors in Rule 506 offerings include accredited
investors (both natural persons and legal entities) and non-accredited
investors who meet certain ``sophistication'' requirements. Each of
these market participants is discussed in further detail below.
a. Issuers
Based on the information submitted in 112,467 new and amended Form
D filings between 2009 and 2012, there were 67,706 new Regulation D
offerings by 49,740 unique issuers during this four-year period.\260\
The size of the average Regulation D offering during this period was
approximately $30 million, whereas the size of the median offering was
approximately $1.5 million.\261\ The difference between the average and
median offering sizes indicates that the Regulation D market is
comprised of many small offerings, which is consistent with the view
that many smaller businesses are relying on Regulation D to raise
capital, and a smaller number of much larger offerings.
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\260\ See Ivanov/Bauguess Study.
\261\ See id. The average and median amounts are calculated
based on the amounts sold by Regulation D issuers as reported in
their Form D filings. A study of unregistered equity offerings by
publicly-traded companies over the period 1980-1996 found that the
mean offering amount was $12.7 million, whereas the median offering
amount was $4.5 million. See M. Hertzel, M. Lemon, J. Linck, and L.
Rees, Long-Run Performance Following Private Placements of Equity,
57 Journal of Finance (2002), 2595-2617.
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Some information about issuer size is available from Item 5 in Form
D, which calls for issuers in Regulation D offerings to report their
size in terms of revenue ranges or, in the case of certain pooled
investment funds, net asset value ranges. All issuers can currently
choose not to disclose this size information, however, and a
significant majority of issuers that are not pooled investment funds
declined to disclose their revenue ranges in the Forms D that they
filed between 2009 and 2012. For those that did, most reported a
revenue range of less than $1 million (Figure 3).\262\ During the 2009-
2011 period, approximately 10% of all public companies raised capital
in Regulation D offerings; in 2012, approximately 6% of such companies
did so.\263\ These public companies tended to be smaller and less
profitable than their industry peers, which illustrates the
significance of the private capital markets to smaller companies,
whether public or private.\264\
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\262\ See Ivanov/Bauguess Study.
\263\ Id. (explaining methodology of using listings in the
Standard & Poor's Compustat database and the University of Chicago's
Center for Research in Securities Prices database to determine which
companies were public companies).
\264\ Id.
[GRAPHIC] [TIFF OMITTED] TR24JY13.007
During this period, pooled investment funds conducted approximately
24% of the total number of Regulation D offerings and raised
approximately 81% of the total amount of capital raised in Regulation D
offerings.\265\ More than 75% of pooled investment funds declined to
disclose their net asset value range.
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\265\ Id.
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[[Page 44756]]
[GRAPHIC] [TIFF OMITTED] TR24JY13.008
Between 2009 and 2012, approximately 66% of Regulation D offerings
were of equity securities, and almost two-thirds of these were by
issuers other than pooled investment funds.\266\ Non-U.S. issuers
accounted for approximately 19% of the amount of capital raised in
Regulation D offerings, indicating that the U.S. market is a
significant source of capital for these issuers.\267\
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\266\ Id.
\267\ Id.
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b. Investors
We have relatively little information on the types and number of
investors in Rule 506 offerings. Form D currently requires issuers in
Rule 506 offerings to provide information about the total number of
investors who have already invested in the offering and the number of
persons who do not qualify as accredited investors.\268\ In 2012,
approximately 153,000 investors participated in offerings by operating
companies, while approximately 81,000 investors invested in offerings
by pooled investment funds.\269\ Because some investors participate in
multiple offerings, these numbers likely overestimate the actual number
of unique investors in these reported offerings. In offerings under
Rule 506(b), both accredited investors and up to 35 non-accredited
investors who meet certain sophistication requirements are eligible to
purchase securities. In offerings under new Rule 506(c), only
accredited investors will be eligible to purchase securities.
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\268\ See Item 14 of Form D. Form D does not require any other
information on the types of investors, such as whether they are
natural persons or legal entities.
\269\ These numbers are based on initial Form D filings
submitted in 2012.
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Information collected from Form D filings indicates that most Rule
506 offerings do not involve broad investor participation. More than
two-thirds of these offerings have ten or fewer investors, while less
than 5% of these offerings have more than 30 investors. Although Rule
506 currently allows for the participation of non-accredited investors
who meet certain sophistication requirements, such non-accredited
investors reportedly purchased securities in only 11% of the Rule 506
offerings conducted between 2009 and 2012.\270\ Only 8% of the
offerings by pooled investment funds included non-accredited investors,
compared to 12% of the offerings by other issuers.\271\
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\270\ See Ivanov/Bauguess Study.
\271\ Id.
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[[Page 44757]]
[GRAPHIC] [TIFF OMITTED] TR24JY13.009
As stated above, between 2009 and 2012, the size of the median
Regulation D offering, based on the information in Form D filings, was
approximately $1.5 million. The presence of so many relatively small
offerings suggests that a sizable number of current investors in Rule
506 offerings are natural persons or legal entities in which all equity
owners are natural persons. This is because smaller offerings may not
provide sufficient scale for institutional investors to earn a sizable
return. Institutional investors typically have a larger investible
capital base and more formal screening procedures compared to investors
who are natural persons, and the associated costs of identifying
potential investments and monitoring their investment portfolio lead
them to make larger investments than natural persons.\272\ As for
whether natural persons investing in these offerings are accredited
investors or non-accredited investors, almost 90% of the Regulation D
offerings conducted between 2009 and 2012 did not involve any non-
accredited investors.\273\
---------------------------------------------------------------------------
\272\ See, e.g., George Fenn, Nellie Liang and Stephen Prowes,
The Economics of Private Equity Markets. (1998); Steven Kaplan and
Per Stromberg, Leveraged Buyouts and Private Equity, Journal of
Economic Perspectives (2009).
\273\ See Ivanov/Bauguess Study.
---------------------------------------------------------------------------
While we do not know what percentage of investors in Rule 506
offerings are natural persons, the vast majority of Regulation D
offerings are conducted without the use of an intermediary,\274\
suggesting that many of the investors in Regulation D offerings likely
have a pre-existing relationship with the issuer or its management
because these offerings would not have been conducted using general
solicitation. This category of investors is likely to be much smaller
than the total number of eligible investors for Rule 506(c) offerings,
which is potentially very large. We estimate that at least 8.7 million
U.S. households, or 7.4% of all U.S. households, qualified as
accredited investors in 2010, based on the net worth standard in the
definition of ``accredited investor'' (Figure 6).\275\
---------------------------------------------------------------------------
\274\ An analysis of all Form D filings submitted between 2009
to 2012 shows that approximately 11% of all new offerings reported
sales commissions of greater than zero because the issuers used
intermediaries. See Ivanov/Bauguess Study. We assume that the lack
of a commission indicates the absence of an intermediary.
\275\ This estimate is based on net worth and household data
from the Federal Reserve Board's Triennial Survey of Consumer
Finances (``SCF'') 2010. Our calculations are based on 32,410
observations in the 2010 survey.
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[[Page 44758]]
[GRAPHIC] [TIFF OMITTED] TR24JY13.010
Our analysis, however, leads us to believe that only a small
percentage of these households are likely to participate in securities
offerings, especially exempt offerings. First, as mentioned above, data
from Form D filings in 2012 suggests that fewer than 234,000 investors
(of which an unknown subset are natural persons) participated in
Regulation D offerings, which is small compared to the 8.7 million
households that qualify as accredited investors. Second, evidence
suggests that only a small fraction of the total accredited investor
population has significant levels of direct stockholdings. Based on an
analysis of retail stock holding data for 33 million brokerage accounts
in 2010, only 3.7 million accounts had at least $100,000 of direct
investments in equity securities issued by public companies listed on
domestic national securities exchanges, while only 664,000 accounts had
at least $500,000 direct investments in such equity securities (Figure
7).\276\ Assuming that investments in publicly-traded equity securities
are a gateway to investments in securities issued in exempt offerings,
and accredited investors with investment experience in publicly-traded
equity securities are more likely to participate in an exempt offering
than accredited investors who do not, the set of accredited investors
likely to be interested in investing in Rule 506(c) offerings could be
significantly smaller than the total accredited investor population.
---------------------------------------------------------------------------
\276\ This analysis by DERA is based on the stock holdings of
retail investors from more than 100 brokerage firms covering more
than 33 million accounts during the period June 2010-May 2011.
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[[Page 44759]]
[GRAPHIC] [TIFF OMITTED] TR24JY13.011
c. Investment Managers
Based on Form ADVs that were filed with the Commission as of June
2013, there were 7,772 SEC reporting investment advisers that have
clients that are private funds, registered investment companies
business development companies, or other pooled investment vehicles.
These investment advisers include:
Registered investment advisers. Data filed for 2012 show
that there were approximately 5,400 Commission-registered investment
advisers with pooled investment fund clients that filed Form ADV with
the Commission. These 5,400 investment advisers represent approximately
$45.3 trillion total assets under management for pooled investment
funds, or average assets under management of $8.4 billion per adviser.
Of these, 4,044 investment advisers had clients that were private
funds, with total assets under management of $35.2 billion and average
assets under management of $8.6 billion.
Exempt reporting advisers. These are investment advisers
that are required to report on Form ADV but not to register with the
Commission (for example, investment advisers to venture capital funds).
Based on ADV data, there were 2,303 exempt reporting advisers in 2012,
all of which had pooled investment funds as clients, with approximately
$1.6 trillion of assets under management.
We do not have information regarding investment advisers with
assets under management of less than $100 million, which are not
generally required to register with the Commission, or investment
managers that advise pooled investment funds with respect to
investments in assets other than securities, such as commodities or
real estate.
d. Broker-Dealers
As of December 2012, there were 4,450 broker-dealers registered
with the Commission who file on Form X-17A-5, with average total assets
of approximately $1.1 billion per broker-dealer. The aggregate total
assets of these registered broker-dealers are approximately $4.9
trillion. Of these registered broker-dealers, 410 are dually registered
as investment advisers. The dually registered broker-dealers are larger
(average total assets of $6.4 billion) than those that are not dually
registered. Among the dually registered broker-dealers, we identified
24 that currently have or have had private funds that submitted Form D
filings between 2002 and 2012.
3. Estimated Incidence of ``Bad Actors'' in Securities Markets
Generally
The economic impact of the rule amendments primarily depends on the
extent to which they succeed in reducing fraud in the Rule 506
marketplace. This, in turn, depends on multiple factors, including the
incidence of bad actors in Rule 506 offerings, the recidivism rate of
such bad actors and the potential deterrent effect of disqualification
as a sanction.
The disqualification rules should reduce the participation of both
new and existing bad actors in Rule 506 offerings. Offerings will no
longer be eligible to rely on Rule 506 if they involve a covered person
that becomes a bad actor because of a triggering event that occurs
after the new rules take effect. While triggering events existing
before effectiveness of the rule will not be disqualifying, issuers
will be required to provide disclosure about such events to investors.
Participation in Rule 506 offerings by bad actors not disqualified by
the rules we adopt today may, therefore, also be limited if issuers or
investors are reluctant to transact with bad actors or participate in
transactions involving bad actors once they become aware of the bad act
through the required disclosure.
The effects of disqualification also depend on the likelihood that
participation of bad actors in Rule 506 offerings would lead to the
recurrence in perpetration of triggering events. This depends on the
recidivism rates among bad actors.
[[Page 44760]]
Finally, the passage of the rule, through the deterrent effect of a
potential threat of disqualification, could have the indirect impact of
reducing the number of bad actors in the securities markets and the
conduct resulting in sanctions that trigger disqualification.
Although it is impossible to predict future market participant
behavior that may arise in response to the adopted rules, we can
quantify, in certain instances, past occurrences of certain triggering
events to provide an estimate of the historical incidence of bad
actors--as determined under the new rules--in securities markets as a
general matter.
Identification of Triggering Events. To assess the incidence in the
securities markets of potentially disqualifying ``bad actors,'' we
examined the legal proceedings brought by the Commission during the
five-year period from 2007 to 2011 in which the sanctions imposed would
constitute triggering events under the new rule. We searched records of
public proceedings, including case name, defendant name, code section
violation, and sanction. To conduct the search, we used search terms
pertaining to:
Injunctions and court orders (which we refer to
collectively as ``injunctions'') against conduct or practices in
connection with the purchase or sale of a security, involving the
making of a false filing with the Commission, or arising out of the
conduct of business of certain financial intermediaries, as provided in
Rule 506(d)(1)(ii);
Commission disciplinary orders under Section 15(b) or
15B(c) of the Exchange Act or Section 203(e) or (f) of the Advisers Act
that suspend or revoke registration, limit activities or bar a person
from association with a regulated entity or from participation in a
penny stock offering, as provided in Rule 506(d)(1)(iv); and
Commission cease-and-desist orders relating to violations
of scienter-based anti-fraud provisions of the federal securities laws
or violations of Section 5 of the Securities Act, as provided in Rule
506(d)(1)(v).
Our analysis did not consider other bad actor triggering events in Rule
506(d)(1), primarily because we do not have a comparable ability to
search databases relevant to criminal convictions or the actions of
relevant state and other federal regulators.\277\ In addition, it is
possible that the search techniques used by staff may not have
identified all relevant potential triggering events and bad actors.
Since our analysis is subject to these limitations, our estimates of
the incidence of potential bad actors likely represent a lower bound.
On the other hand, not all of the bad actors identified in our search
would be expected to be involved with Rule 506 offerings.
---------------------------------------------------------------------------
\277\ We have limited information available on enforcement
activity by state securities regulators, discussed at the text
accompanying note 283. Our analysis did not cover felony and
misdemeanor convictions as provided in Rule 506(d)(1)(i); final
orders of state authorities and Federal banking agencies and
National Credit Union Association as provided in Rule
506(d)(1)(iii); disciplinary actions by a national securities
exchange or an affiliated securities association, as provided in
Rule 506(d)(1)(vi); and United States Postal Service orders as
provided in Rule 506(d)(vii). We also excluded refusal, stop, or
suspension orders pertaining to registration statements or
Regulation A offering statements, as provided in Rule
506(d)(1)(vii), because they are too infrequent to affect our
analysis.
---------------------------------------------------------------------------
Our search of Commission enforcement actions identified a sample of
2,578 persons, including both individuals and entities, that received
injunctions, disciplinary orders, and/or cease-and-desist orders,
issued in a total of 1,485 enforcement cases over the five-year period.
We found that an aggregate of 3,053 disqualifying sanctions (1,943
injunctions, 853 disciplinary orders, and 257 cease-and-desist orders)
were imposed upon these persons. In some instances, a person received
more than one sanction, which in most cases consisted of a combination
of an injunction and a disciplinary order.\278\ Each one of these
sanctions would have constituted a triggering event under this rule,
which would have disqualified any offering from relying on Rule 506 if
the person were a ``covered person,'' such as a director or executive
officer of the issuer or a financial intermediary. The following chart
shows the breakdown of triggering events by type:
---------------------------------------------------------------------------
\278\ One case involving both an injunction and a cease-and-
desist order is not reflected in the chart titled ``Triggering
Events: 2007-2011'' due to rounding.
[GRAPHIC] [TIFF OMITTED] TR24JY13.012
[[Page 44761]]
In the cases we identified, between 70% and 78% of triggering events
each year were against individuals, with the remainder against
entities. With 83,521 offerings that relied on Rule 506 during the
period under review, the incidence of detected bad actors is
approximately 0.03 per offering. These numbers represent, however, only
enforcement actions brought by the Commission. These numbers do not
reflect enforcement action by other authorities (for example, state
level regulators), nor do they include undetected bad actors.
While all of the 2,578 identified bad actors would disqualify any
offering in which they were involved from reliance on Rule 506, not all
of the bad actors would be expected to be involved with Rule 506
offerings. Many of the triggering events, such as insider trading,
involve bad actors engaged in secondary market transactions. These
persons may present a lesser risk of entering primary issuance markets
such as Rule 506. Hence, the aggregate number of bad actors may
overestimate the incidence of bad actors operating in the Rule 506
market. To more accurately estimate the likelihood that a bad actor
might be involved in the issuance of securities, we identify triggering
events involving a Section 5 violation.\279\ As reflected in the chart
``Bad Actors by Year and Violation'' below, approximately 29% of the
bad actors (a total of 748) were sanctioned for Section 5 violations. A
similar percentage, approximately 25%, were sanctioned for the next-
largest category of violations, those involving false filings.\280\ The
remaining bad actors fall into the ``Other'' category, of which insider
trading-related violations represent the largest single sub-category.
The following chart shows this breakdown:
---------------------------------------------------------------------------
\279\ Bad actors included in the Section 5 category may have
also violated other securities law provisions, such as anti-fraud
provisions in Section 17(a) of the Securities Act and Section 10(b)
of the Exchange Act. Using Section 5 violations as a proxy for
involvement in a securities offering may be under inclusive, as
there may be offering-related misconduct without a Section 5
violation.
\280\ We define false filing as violations relating to errors
and omissions in Commission filings, such as periodic reports, Form
BD, Form ADV and beneficial ownership reports.
[GRAPHIC] [TIFF OMITTED] TR24JY13.013
To assess the quality of the search results, from the 1,485 cases
previously identified, we selected a random sample of 190 cases, a
sample that is large enough to provide a low margin of error. Because a
single case produces multiple triggering events if multiple persons are
named, the sample of 190 cases included 529 potential triggering events
and allows for a margin of error of less than 5% in our analysis.\281\
Commission staff reviewed the orders, releases, and other documentation
for all 190 cases to determine whether each potential triggering event
actually met the criteria specified in Rule 506(d)(1)(ii), (iv) or (v).
The review of the search results showed that the search criteria
applied produced relatively accurate results.\282\
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\281\ The margin of error in these estimates based on the sample
size of 529 potential triggering events is approximately 3.6% at the
90% confidence level. Taking these results together, there may be as
many as 30 more or 30 fewer disciplinary orders than what is
estimated at the 90% confidence level.
\282\ The misclassification rate for injunctions, disciplinary
orders, and cease and desist orders was 4%, 30%, and 0%
respectively. While the misclassification rate for disciplinary
orders was high, the sample results for disciplinary orders
contained nearly the same number of false positives (events
classified as disciplinary orders that did not actually meet the
criteria of Rule 506(d)(1)(iv)) as false negatives (events
classified as injunctions and/or cease-and-desist orders that turned
out to also include disciplinary orders), so the error in the total
number of estimated disciplinary orders based on the sample review
is significantly less than 30%. Accounting for offsetting
misclassifications--i.e., false positives and false negatives--the
error rate in the total number of estimated disciplinary orders
falls to 1%.
---------------------------------------------------------------------------
Incidence of Bad Actors Potentially Participating in Primary
Offerings of Securities. Staff further refined the estimate of the
likelihood that triggering events that were related to the Rule 506
market using the random sample of 190 cases. In particular, staff
identified whether each of the cases involved an offering of securities
by the issuer, which we refer to as a primary offering. For cases
involving a primary offering, staff identified whether the offering was
registered or unregistered. The review showed that 70 out of the 190
cases (or
[[Page 44762]]
37%) involved a primary offering, all of which were unregistered, and
of the 529 potential triggering events included in the 190 cases, 251
(or 47%) involved a primary offering.
For purposes of the review, defendants or respondents were
categorized as ``issuers,'' ``intermediaries,'' and ``other persons.''
``Issuers'' are entities that issue securities and the individuals who
were affiliated with that issuer. ``Intermediaries'' are entities and
individuals that facilitate securities offerings and investments, like
brokers and non-affiliated investment advisers. ``Other persons'' are
persons who are neither issuers nor intermediaries; the staff found
that, in general, these were persons found liable for trading on inside
information.
The following table summarizes the staff's findings with respect to
these cases:
Summary of Bad Actors and Case Type for 2007 to 2011 Period
------------------------------------------------------------------------
Subset of sample
Random sample of relating to
enforcement cases unregistered
offerings
------------------------------------------------------------------------
Number of cases................. 190 70 (37%)
Number of triggering events 529 251 (47%)
--issuers................... 278 160
--intermediaries............ 189 76
--entities acting as both 17 15
issuers and intermediaries.
--other persons............. 45 0
------------------------------------------------------------------------
Of the 529 bad actors in the sample, staff found that 278 were
issuers, 189 were intermediaries, 17 were entities that could qualify
as either an issuer or an intermediary (such as a promoter who is
employed by an issuer), and 45 were other persons.
Based on projections from our review of this sample, we estimate
that during the 2007 to 2011 review period, 549 cases (37% of the 1,485
total cases) involved an unregistered offering and approximately 1,212
bad actors (47% of the 2,578 total bad actors identified) participated
in those unregistered offerings. We consider these estimates as a lower
bound for the number of bad actors because our analysis does not take
into account bad actor triggering events other than those in
subsections (ii), (iv), and (v) of Rule 506(d)(1) or offerings
involving bad actors that did not give rise to enforcement activity.
Taking those into account, the total number of bad actors is likely to
be higher.
We considered other data sources regarding the number of bad actor
triggering events not involving Commission action. NASAA's 2012
Enforcement Report presents some data on orders by state securities
regulators between 2009 and 2011,\283\ which would pertain to
subsection (iii) of Rule 506(d)(1), relating to final orders and bars
issued by state securities, insurance and banking regulators, federal
banking regulators and the National Credit Union Administration. The
report states that, as a result of state securities regulatory actions,
8,744 licenses were withdrawn and 1,952 licenses were denied, revoked,
suspended, or conditioned in that three-year period. This data,
however, may be over inclusive for purposes of establishing the number
of bad actors under Rule 506(d) for a number of reasons. First, not all
of the actions appear to be ``final orders'' under subsection (iii) of
Rule 506(d)(1) (e.g., some licenses were withdrawn rather than
revoked). In addition, there is potential double counting in the NASAA
survey when different states take action against the same person, as
well as potential double counting between Commission and NASAA data for
bad actors subject to both Commission and state sanctions. The data
could also be under inclusive, in that it covers only actions by state
securities regulators, whereas under subsection (iii) of Rule
506(d)(1), disqualification may also be triggered by orders of state
insurance, banking, savings association and credit union regulators;
appropriate federal banking regulators; and the National Credit Union
Association. Staff were not able to identify comparable sources of data
on these other types of orders.\284\
---------------------------------------------------------------------------
\283\ North American Securities Administrators Association, 2012
Enforcement Report, Table 4 (available at http://www.nasaa.org/wp-content/uploads/2011/08/2012-Enforcement-Report-on-2011-Data1.pdf).
\284\ FINRA's BrokerCheck database includes this data for
registered broker-dealers and their associated persons, as well as
data on investment advisers and their associated persons drawn from
the Commission's IARD database. See note 202. BrokerCheck is
searchable only by the name of firms and individuals, however, not
by the nature of past violations, which makes it impracticable for
us to use it as a source of data in this review.
---------------------------------------------------------------------------
C. Analysis of Final Rules
Section 926 of the Dodd-Frank Act requires the Commission to adopt
rules excluding felons and other bad actors from participation in Rule
506 offerings. The disqualification provisions of Rule 506 were
intended to \285\ and should lead to enhanced investor protection by
reducing the number of offering participants who have previously
engaged in fraudulent activities or who previously violated securities,
insurance, banking or credit union laws or regulations, and by
providing an additional deterrent to future fraudulent activities.
Currently, persons covered by the disqualification provisions of these
rules, such as issuers and compensated solicitors, are subject to a
multilayered securities enforcement system that includes the
Commission, state securities regulators and, for financial industry
participants, FINRA. The disqualification rules we adopt today should
alter industry practice by inducing issuers and other covered persons
to implement additional measures to restrict bad actor participation in
Rule 506 offerings.
---------------------------------------------------------------------------
\285\ Statement of Senator Christopher Dodd, 156 Cong. Rec.
S3813 (daily ed. May 17, 2010).
---------------------------------------------------------------------------
In the proposing release, we solicited comment on the costs and
benefits of the proposed rules. While no comment letters provided
quantitative data or directly addressed the cost-benefit analysis
included in the proposing release, a number of commenters did mention
potential costs and benefits of the proposed rule. Our response to
these comments is discussed in Section II above, and we briefly discuss
these comments where they are relevant in the discussion below.
1. Effects of the Statutory Mandate
To the extent the new disqualification provisions result in a
reduction of fraud in the Rule 506 offering market, investor losses to
fraud will be reduced and investor willingness to participate in the
[[Page 44763]]
Rule 506 market could increase. This should lower the issuance costs
for Rule 506 offerings to the extent that new disqualification
standards lower the risk premium associated with the presence of bad
actors in securities offerings.\286\ Lower costs in the Rule 506
offering market could improve conditions for capital formation,
benefitting both issuers and investors. In this regard, commenters also
emphasized investor protection \287\ and increased participation in the
private placement market as the main benefits of the rule.\288\
---------------------------------------------------------------------------
\286\ In a related framework, Karpoff et al. (2008) show that
the marketplace imposes significant penalties on firms targeted by
SEC enforcement actions for financial misrepresentation, where for
each dollar of misrepresentation the firm loses an additional $3.08
due to expected legal penalties and loss of reputation. See J.
Karpoff, D. Lee & G. Martin, The Cost to Firms of Cooking the Books,
581-611 Journal of Financial & Quantitative Analysis (Sept. 2008).
\287\ See comment letters from M. Zhu; DTC; Better Markets;
NASAA.
\288\ See comment letter from Better Markets.
---------------------------------------------------------------------------
The new disqualification provisions may also benefit investors by
reducing the burden of the ``due diligence'' investigation they conduct
on persons and entities involved in the offerings in which they invest.
Without bad actor disqualification, investors seeking information about
the background of issuers and the people involved with them would have
to perform separate investigations due to the cost of coordinating
collective action. Requiring issuers to determine whether any persons
or entities are subject to an event that triggers disqualification may,
for some investors, obviate the need to do their own investigation,
which may eliminate some of the redundancies in these separate
investigations. Given the issuer's advantage in accessing much of the
relevant information, issuers should be able to perform the task at a
lower cost than most individual investors.
The disqualification requirements also impose costs on issuers,
covered persons and investors. In our analysis under the Paperwork
Reduction Act in Part III.B above, we estimate that most issuers will
bear an additional cost of $400 to conduct a factual inquiry to
determine whether any covered persons had a disqualifying event that
occurred before the effective date of the rule amendments.\289\ We also
estimate that approximately 220 \290\ Rule 506 issuers will spend
$5,200 on average for using in-house and outside professional services
in preparing a disclosure statement describing matters that would have
triggered disqualification under Rule 506(d)(1) of Regulation D had
they occurred on or after the effective date of the rule amendments.
These cost estimates are based on assumptions outlined in Part IV.B.3
above and represent lower bound estimates, given that our analysis in
Part IV.B.3 did not cover all possible bad actor triggering events. We
note, in addition, that the Paperwork Reduction Act analysis is not
required to, and does not, consider all potential costs that market
participants may incur in complying with Rule 506(d). Further, we
cannot predict how issuers will respond to the possibility of having to
disclose the participation of a bad actor in an offering; the issuer
could disclose, remove the person from the offering, abandon the
offering, or conduct an offering that does not require disclosure.
---------------------------------------------------------------------------
\289\ We assume the cost of in-house attorney services to be
$400 per hour. This estimate is based on data provided in the report
titled Management and Professional Earnings in the Securities
Industry--2012, which is published by the Securities Industry and
Financial Markets Association.
\290\ Staff estimates that there were at least 549 SEC
enforcement actions involving an unregistered offering in which
someone who would be disqualified as a bad actor participated in the
five years from 2007 through 2011. See Part IV.B.3.
---------------------------------------------------------------------------
Issuers that are disqualified from reliance on Rule 506 will bear
costs to the extent that alternative means of raising capital are
unavailable or involve higher transaction costs that result in a higher
cost of capital. In some circumstances, issuers may postpone or forgo
capital raising, deferring engagement in potentially value-enhancing
projects. This could entail forgone investment opportunities for
disqualified issuers and for investors who otherwise would have
invested in such issuers. Issuers that pursue alternative capital
raising methods may incur higher costs associated with their capital
raising. For example, all other things being equal, transaction costs
are likely to be higher for issuers that raise capital in reliance on
Section 4(a)(2) of the Securities Act outside of Rule 506 because of
higher costs to comply with state securities law requirements and
greater legal uncertainty about the requirements of the exemption. In
addition, issuers eligible to rely on new Rule 506(c) will be able to
use general solicitation and general advertising to find potential
investors if all purchasers in their offering are accredited investors
and the issuer takes reasonable steps to verify their accredited
investor status,\291\ whereas issuers seeking an exemption under
Section 4(a)(2) outside of Rule 506(c) will continue to be constrained
by the incompatibility of a claim of exemption under Section 4(a)(2)
and general solicitation or general advertising.\292\ This may further
differentiate transaction costs and cost of capital between Section
4(a)(2) offerings and Rule 506(c) offerings. Registered securities
offerings can also result in higher transaction costs than private
offerings, and in addition trigger ongoing reporting
responsibilities.\293\ As highlighted above, 22% of Rule 506 issuers
that reported revenues on Form D indicated that their revenues were
less than $1 million. For these and similarly sized issuers, going
public through a registered offering may not be a feasible substitute
for a Rule 506 offering.\294\
---------------------------------------------------------------------------
\291\ As discussed above, we are adopting new Rule 506(c), 17
CFR 230.506(c), today. See Eliminating the Prohibition Against
General Solicitation and General Advertising in Rule 506 and Rule
144A Offerings, Release No. 33-9415 (July 10, 2013).
\292\ Id. at note 42 and accompanying text.
\293\ A 2011 report prepared by a group called the ``IPO Task
Force,'' which consisted of a group of professionals, including
venture capitalists, experienced CEOs, public investors, securities
lawyers, academics and investment bankers, estimated that the cost
of going and staying public are high. Chart H of the IPO Task Force
Report estimates that the average cost to go public is $2.5 million
and the annual cost of staying public is $1.5 million. See
Rebuilding the IPO On-Ramp: Putting Emerging Companies and the Job
Market Back on the Road to Growth (publicly available at http://www.sec.gov/info/smallbus/acsec/rebuilding_the_ipo_on-ramp.pdf).
\294\ For example, if an issuer intends to raise a small amount
of capital to fund its operations, the costs of conducting a
registered offering may make a registered offering impracticable. In
addition, private funds that rely on exemptions from investment
company registration under Section 3(c)(1) or 3(c)(7) of the
Investment Company Act are not permitted to conduct public
securities offerings.
---------------------------------------------------------------------------
Issuers may also incur costs in connection with changes to
personnel, governance structures and capital raising plans as a result
of disqualification. For example, issuers may incur costs from
terminating disqualified individuals or from reassigning them to
positions where they will not trigger a disqualification in the context
of an offering, and hiring new personnel or retraining existing
personnel to replace them. They may also incur costs incident to
restructuring their governance and control arrangements if, for
example, a general partner, managing member or investment manager of a
pooled investment fund issuer is a bad actor whose involvement would
result in the disqualification of the offering. Issuers may also incur
costs in connection with terminating an engagement with a placement
agent or other covered financial intermediary, and entering into a new
engagement. Smaller issuers and issuers with limited operating
histories may not be able to readily find a new placement agent or
other financial intermediary.
[[Page 44764]]
The final rule will include as covered persons the beneficial
owners of 20% or more of the issuer's outstanding voting equity,
calculated on the basis of voting power. This reflects a change from
the 10% or more beneficial ownership of any class of the issuer's
equity originally proposed. The higher ownership standard, limitation
to voting securities and calculation focused on voting power would
increase the likelihood that the disqualified investor is more closely
affiliated with the issuer and has greater input or control over the
management of the issuer.\295\ In our judgment, the higher threshold
will therefore provide greater certainty that the investor has some
level of influence with the issuer. In addition, because issuers cannot
necessarily prohibit a bad actor from establishing a large ownership
position, particularly when an issuer's security is traded among non-
affiliates or in a secondary market, a higher threshold is expected to
reduce the likelihood of a disqualifying event affecting an issuer in
cases where a securityholder with a disqualifying bad act meets the
beneficial ownership threshold in the rule but does not in fact
exercise control or influence over the issuer. Lower uncertainty and
relatively fewer ``covered persons'' arising from the amendment would
reduce the costs of monitoring and due diligence for complying with the
rule, and should limit the circumstances in which issuers must seek
waivers from disqualification based on the involvement of bad actor
investors that do not exercise influence or control over the issuer.
---------------------------------------------------------------------------
\295\ It would also be in line with the level at which filing as
a passive investor is no longer permitted on Schedule 13G under
Regulation 13D-G. See 17 CFR 230.13d-1(c).
---------------------------------------------------------------------------
At the same time, determining whether a securityholder is covered
based on ownership of voting securities, calculating ownership based on
voting power across all outstanding securities rather than a single
class and raising the threshold from 10% to 20% could reduce investor
protection benefits, as securityholders whose ownership does not meet
the threshold provided in the final rule, but who exercise control of
an issuer, would not be covered. The inclusion of directors, officers
and their functional equivalents under the definition of covered
persons, however, may mitigate this effect; the rule will cover
investors who serve those functions in relation to the issuer,
regardless of their level of ownership.
With respect to 20% beneficial owners that are subject to
triggering events, issuers may incur costs to buy out or otherwise
induce such persons to reduce their ownership positions. Issuers may
also incur costs in connection with taking steps to prevent bad actors
from becoming 20% beneficial owners, such as exercising rights of first
refusal and excluding bad actors from financing rounds. For certain
issuers, finding investors to replace the capital represented by these
shareholders or potential investors, as the case may be, could be
challenging and expensive. Some commenters also expressed concerns
about the aggregate costs of the proposed bad actor rule, saying that
its provisions are generally unduly complex, unclear or not based on
objective, bright-line standards.\296\ Others expressed concerns about
the potential burdens on capital raising,\297\ and that it could
undermine the overall utility of Rule 506.\298\
---------------------------------------------------------------------------
\296\ See comment letters from ABA Fed. Reg. Comm.; NYCBA;
Cleary Gottlieb.
\297\ See comment letters from B. Nelson; Coy Capital; Five
Firms; S&C.
\298\ See Angel Capital Comment Letter 1; see also comment
letters from ABA Fed. Reg. Comm.; Karr Tuttle; SIFMA; S&C.
---------------------------------------------------------------------------
Issuers may also incur costs in connection with seeking waivers of
disqualification from the Commission, or determinations by other
authorities (such as state securities regulators) that their orders
should not give rise to disqualification under Rule 506(d).
The new disqualification standards may also impose costs on other
market participants that are subject to triggering events, such as
financial intermediaries, by making them ineligible to participate in
the market for Rule 506 offerings. For affected individuals, this may
result in demotion or termination of employment, limitations on career
advancement and fewer employment opportunities generally. For affected
firms, this may result in revenue reductions and loss of market share,
and could threaten the continued operation of firms that are heavily
dependent on Rule 506 offerings as a source of revenue. Firms that are
not themselves disqualified but whose officers, directors, general
partners and managing members are subject to disqualifying events may
incur additional costs from terminating or reassigning such individuals
and from hiring new personnel or retraining existing personnel to
replace them.
Bad actor disqualification rules may also impose costs on issuers
and other market participants beyond the context of Rule 506 offerings.
For example, imposing a new disqualification standard only on offerings
under Rule 506, rather than on a more uniform basis, may result in
higher costs for issuers relying on other exemptive rules, to the
extent that differing disqualification standards create confusion and a
more difficult compliance regime. Adopting uniform disqualification
provisions throughout the Securities Act was cited by some commenters
as a benefit, in that it could simplify compliance and increase overall
investor protection.\299\
---------------------------------------------------------------------------
\299\ See comment letters from ABA Fed. Reg. Comm.; C. Barnard;
Better Markets; NASAA.
---------------------------------------------------------------------------
In addition, non-uniform application of the new disqualification
standards may encourage bad actors to migrate to offerings under other
exemptions. Investors may perceive a higher risk of fraud in such
offerings, which would be detrimental to their marketability and result
in greater issuance costs of all offerings under the exemptions that
are not subject to the new standards, whether or not bad actors are
involved. This could have an effect on competition by putting issuers
that are not eligible to use Rule 506 at a competitive disadvantage.
Finally, there is a potential cost to investors of overreliance on
Rule 506(d) in assessing the risks associated with an offering. Fraud
can still occur without prior incidence of bad acting on the part of
the issuer or covered persons, and in some cases it is possible that
prior bad actions went undetected or did not otherwise result in a
sanction, or may have resulted in a sanction that does not constitute a
triggering event for disqualification.
2. Discretionary Amendments
The amendments not specifically required under the Section 926
mandate involve costs and benefits as analyzed below.
Reasonable Care Exception. The ``reasonable care'' exception allows
continued reliance on the Rule 506 exemption, despite the existence of
a disqualification with respect to a covered person, if the issuer can
show that it did not know and, in the exercise of reasonable care,
could not have known that the disqualification existed at the time of
the sale of securities. We anticipate that the ``reasonable care''
exception will provide benefits to the efficiency of the private
placement and capital formation process by removing a significant
disincentive to issuers' use of Rule 506 that would have arisen if
disqualification were applied on a strict liability basis. Without a
reasonable care exception, issuers might choose not to undertake
offerings in reliance on Rule 506, because of the risk of Section 5 or
blue sky law violations in circumstances that the issuer cannot
reasonably predict or control. In those circumstances,
[[Page 44765]]
alternative approaches to capital raising may be more costly to the
issuer or not available at all. Given that Rule 506 is the most
frequently relied-upon Securities Act exemptive rule, the impact of
issuers shifting away from it could be significant. We believe that the
reasonable care exception provides a measured and balanced approach to
preserve the intended benefits of Rule 506, which might otherwise be
impaired because of issuer concerns about strict liability for unknown
disqualifications.
Commenters uniformly supported the reasonable care exception, but
also urged the Commission to provide greater clarity and specificity
about what steps would constitute reasonable care. Some commenters
raised concerns about compliance costs if the requirements of the
``reasonable care'' exception are too burdensome.\300\ We do not
believe it is appropriate to delineate and prescribe specific steps as
being necessary or sufficient to establish reasonable care. We believe
issuers should consider the totality of the offering taking into
account the circumstances of the offering, the covered persons involved
in the offering and the rule's requirements, which include specific
disqualifying events and covered persons subject to those disqualifying
events. The flexibility in permitting issuers to determine their own
methodology for factual inquiry is a benefit that promotes efficiency
to the extent the issuer is able to tailor its own inquiry without
adherence to uniform standards that may not be applicable or
appropriate in the context of a particular issuer or particular
offering.
---------------------------------------------------------------------------
\300\ See Angel Capital Comment Letter 1; see also comment
letter from S&C.
---------------------------------------------------------------------------
A potential cost of a reasonable care exception is that it may
increase the likelihood that bad actors will be able to participate in
Rule 506 offerings, because issuers may take fewer steps to make
inquiry about offering participants than they would if a strict
liability standard applied. If this occurs, it will decrease the
deterrent effect of the bad actor disqualification rules. To the extent
that the reasonable care exception fails to prevent participation by
bad actors in Rule 506 offerings, the effectiveness of the new
disqualification standard will be impaired.
Issuers may also incur costs associated with conducting and
documenting their factual inquiry into possible disqualifications, so
they can demonstrate the exercise of reasonable care. The fact that the
rule does not specify what steps are required may increase such costs
to the extent that issuers do more to conduct and document their
inquiry than otherwise may be necessary, because of this uncertainty.
Disclosure Requirement for Triggering Events That Predate the
Effectiveness of the Rule Amendments. As adopted, the amendments
include a disclosure requirement designed to increase investor
protection by requiring disclosure of events that would have been
disqualifying had they occurred after the effective date of the
amendments. This is a change from the proposal, under which
disqualification would have arisen with respect to events that occurred
before the amendments took effect.
Under the amendments we are adopting, issuers will be subject to
disqualification only for triggering events that occur after the new
rules take effect. On one hand, this approach will reduce costs that
would otherwise have been incurred by issuers and other market
participants subject to pre-existing triggering events, had they been
disqualified from participating in Rule 506 offerings. On the other
hand, this approach will permit offerings involving past bad actors to
proceed under Rule 506, exposing investors to the risks that arise when
bad actors are associated with an offering. While it is difficult to
determine the net impact of implementing the new disqualification
standards in this way, investors will benefit by having access to
information about events that would be disqualifying if they had
occurred after the effective date. Investors will be able to make their
own determination of the relevance and risks associated with past bad
acts, including recidivism risk, and can request additional
information, elect not to pursue the investment opportunity or
negotiate different terms based on this information.
We anticipate that the decision to require disclosure will provide
a benefit to issuers and investors. We believe the disclosure
requirement will serve as a useful tool to alert investors to the
presence of certain participants in offerings under Rule 506 and allow
them to make more informed investment decisions. Without a disclosure
requirement, investors may have the mistaken impression that bad actors
are no longer allowed to participate in Rule 506 offerings. As there is
no prescribed format, the disclosure could be inserted in a non-
prominent manner, such that an investor who reads the material in a
cursory fashion could remain unaware of the participation of bad actors
in the offering. Issuers could benefit from having flexibility in the
manner of disclosure. In addition, because we have imposed a disclosure
requirement rather than disqualification for pre-existing events,
issuers will not be required to revisit past negotiated settlements or
incur additional costs to request waivers for disqualification. Issuers
will, however, incur costs in connection with the factual inquiry to
determine whether disclosure is required and, if applicable, in
preparing the mandatory disclosure for investors, which we have
described in Section III above. Also, rather than provide the mandatory
disclosure, we expect some issuers may decide to take steps to avoid
having to make a disclosure, such as making changes to personnel or
retaining different compensated solicitors, and in that respect may
incur costs similar to those associated with avoiding or removing a
potential disqualification.
We also recognize that issuers that disclose triggering events may
have greater difficulty attracting investors to their offerings and may
incur a higher cost of capital as a result. We do not have data with
respect to current issuer practices involving disclosure of the
participation of persons with a history of regulatory or other legal
sanctions for securities law violations and, as such, we are unable to
determine the extent to which the disclosure requirement will impact
issuers' cost of capital. If investors are unwilling to participate in
offerings involving prior bad actors, some issuers and other market
participants will, as a practical matter, be excluded from the Rule 506
market and will experience some or all of the impact of
disqualification.
Commission Cease-and-Desist Orders Involving Scienter-Based Anti-
Fraud Violations and Violations of Securities Act Section 5. Under the
rule amendments we adopt today, disqualification will be triggered by
Commission cease-and-desist orders based on violations of scienter-
based anti-fraud provisions of the federal securities laws or Section 5
of the Securities Act. The addition of these categories of Commission
orders as a new triggering event is intended to provide a benefit to
investors by screening out additional bad actors, while reducing the
risk that disqualification would be imposed on securities law violators
who do not pose a significant investor protection concern.
We believe the investor protection benefits of adding Commission
cease-and-desist orders to the disqualification provisions of Rule 506
justify the potential costs to issuers and other covered persons. The
benefits associated with screening bad actors out of the Rule 506
market should not depend on
[[Page 44766]]
whether a particular enforcement action is brought in court or through
a Commission administrative proceeding. Clearly, the absence of
Commission cease-and-desist orders from an investor protection rule
that includes federal judicial proceedings addressing the same legal
violations, and orders by state and other federal regulators addressing
the same conduct, would lead to asymmetry in the administration of
disqualification under Rule 506. We also do not believe that the
addition of Commission cease-and-desist orders is likely to impose a
significant cost to issuers and other covered persons because these
groups may already be subject to other disqualifying orders issued by
the states, federal banking regulators and the National Credit Union
Administration.
It is difficult to predict the extent to which adding these
Commission cease-and-desist orders to the list of disqualifying events
will increase the number of bad actors subject to disqualification from
Rule 506 offerings. In our analysis of disqualifying events from 2007
through 2011 discussed earlier, we attempted to assess the number of
individuals or entities that would be disqualified as bad actors based
solely on Commission cease-and-desist orders described in subsection
(v) of Rule 506(d)(1). We identified 116 cease-and-desist orders
against respondents that were not otherwise subject to a disqualifying
injunction, disciplinary order or felony conviction during the 2007 to
2011 period.\301\ To the extent that these historical levels project
future levels of disqualifying Commission cease-and-desist orders, we
estimate that on an annual basis, there may be approximately 23
individuals or entities disqualified by cease-and-desist orders and not
also by some other triggering event. To provide a context, there were
in excess of 83,521 Rule 506 offerings during the period 2007-2011.
With 116 cease and desist orders during the same period, the potential
disqualification incidence created by Commission cease-and-desist
orders would appear to be quite low (using these inputs, less than
0.15%).
---------------------------------------------------------------------------
\301\ As there is no comprehensive database of triggering
events, the analysis included a review of litigation releases and
other documentation for information on other events that would have
disqualified these respondents. Some of these documents provided
short disciplinary histories, but they are not comprehensive and in
any case would not capture subsequent triggering events.
---------------------------------------------------------------------------
In addition, inclusion of Commission cease-and-desist orders as a
triggering event for bad actor disqualification may change how
settlement negotiations are conducted between respondents and the
Commission. Even after the Commission imposes a disqualifying cease-
and-desist order upon a covered person, the Commission may grant an
appropriate waiver from disqualification based on settlement
negotiations or other remedial measures and steps taken by the covered
person to comply with the Commission cease-and-desist order. We believe
that issuers and other covered persons will be able to consider the
practical consequences of a future Commission cease-and-desist order
and alter their conduct to avoid committing the behavior causing the
violation. Alternatively, they can seek to obtain a waiver of
disqualification in enforcement settlement negotiations.
We anticipate that this additional triggering event will add
minimal incremental costs for issuers, given the requirement in the
rule as adopted to conduct factual inquiry to determine whether the
offering is subject to bad actor disqualification. To the extent that
the addition of a disqualifying event broadens the type and the number
of covered persons who will be disqualified from participation in Rule
506 offerings, it may have a detrimental effect on capital raising
activity by delaying or deterring offerings, or causing issuers to
incur higher transaction costs.
CFTC Orders. Under the rule amendments we adopt today,
disqualification will be triggered by orders issued by the CFTC to the
same extent as orders of the regulators enumerated in Section 926 of
the Dodd-Frank Act (e.g., state securities, insurance and banking
regulators, federal banking agencies and the National Credit Union
Administration). We believe that including orders of the CFTC will
result in the treatment of comparable sanctions similarly for
disqualification purposes, and should enable the disqualification rules
to more effectively screen out felons and bad actors. We note in that
regard that the conduct that would typically give rise to CFTC
sanctions is similar to the type of conduct that would result in
disqualification if it were the subject of sanctions by another
financial services industry regulator. In addition, the CFTC (rather
than the Commission) has authority over the investment managers of
pooled investment funds that invest in commodities and certain
derivatives products; unless Rule 506(d) covers CFTC orders, regulatory
sanctions against those investment managers are not likely to trigger
disqualification.
We have a limited ability to quantify the impact of including CFTC
orders as a new disqualification trigger under Rule 506(d). While we
have access to general information about CFTC enforcement
activity,\302\ we have no systematic way to filter CFTC orders for
connection to Rule 506 offerings or private placements or to isolate
situations in which a participant in a Rule 506 offering would be
subject to disqualification solely on the basis of a CFTC order. While
registered broker-dealers are required to report CFTC proceedings and
orders on Form BD, we have no systematic way to filter Form BD data on
that basis or to identify registered broker-dealers that are likely to
participate in Rule 506 offerings or private placements.
---------------------------------------------------------------------------
\302\ See e.g., Commodity Futures Trading Commission Annual
Performance Report, Fiscal Year 2012 at Appendix A (available here:
http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/2012apr.pdf.) A summary of CFTC enforcement proceedings from 2005
through 2008 is available here: http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/file/pbproceedingsbulletin.pdf.
---------------------------------------------------------------------------
We were able to review disclosures concerning CFTC orders on Form
ADV by registered investment advisers and exempt reporting advisers
with pooled investment fund clients. In on our review of 384 Forms ADV
(as described in detail below), we found six investment adviser firms
associated with pooled investment funds that were subject to CFTC
orders that would constitute triggering events under Rule 506(d).
Definition of ``final order.'' The change in the definition of
``final order'' limiting it to orders under statutory authority that
provides for notice and an opportunity for hearing should have marginal
economic impact for issuers. We do not believe that the incremental
burden of inquiry to determine whether an order was issued under such
authority will have a significant impact. The change could have the
effect of reducing the number of disqualifying events for which issuers
or other market participants might seek waivers which, in cases where
the waiver would have been granted, would reduce costs and could
facilitate capital formation. The economic impact on investors from
this change will depend primarily on the extent to which the additional
procedural requirement results in bad actors that would otherwise be
disqualified remaining eligible to participate in Rule 506 offerings,
and the recidivism rates of those bad actors.
Investment Managers. Under the rule amendments we adopt today,
investment managers of issuers that are pooled investment funds (that
is, investment advisers of pooled investment funds and persons who
provide similar investment advisory
[[Page 44767]]
services to pooled investment funds with respect to assets other than
securities) have been added as a new category of covered person. We
believe that this approach will reduce compliance costs, in that it
represents a ``bright-line'' category of presumed control persons based
on governance and control structures that are typical for pooled
investment fund issuers, replacing a potentially costly fact-intensive
inquiry into whether such persons should be deemed the equivalent of
``directors'' or ``executive officers'' of an issuer organized in
corporate form. The addition of this new category facilitates
equivalent treatment of operating companies and pooled investment funds
under new Rule 506(d).
Incidence of Bad Actors Among Investment Advisers.
i. Analysis of Triggering Events Based on Enforcement Actions Initiated
by the Commission
In the review described above in Section IV.B.3, we found that 47
of the random sample of 529 identified cases involved investment
advisers (18 of these 47 were also broker-dealers). None of these 47
investment advisers was sanctioned in connection with a private
offering. This, however, would represent only a lower bound for the
incidence of bad actor triggering events among investment advisers, as
the analysis was based on a random sample drawn from the legal
proceedings that were brought before the Commission during the period
2007-2011. In addition, our analysis does not take into account bad
actor triggering events other than those in subsections (ii), (iv), and
(v) of Rule 506(d)(1) or offerings involving bad actors that did not
give rise to enforcement activity.
ii. Form ADV Data
We analyzed all Form ADVs filed by investment advisers for 2012 to
determine the reported incidence of disqualification triggering events.
We limited our review to forms filed by investment advisers that:
Advise a private fund or have clients that are registered
investment companies, business development companies or other pooled
investment vehicles;
Provided disclosure reporting pages on their current Form
ADV; and
Indicated that some of the disclosure reporting pages are
for the adviser itself or its supervised persons.
We considered only orders whose status was reported as final. Based on
these criteria, we identified 384 investment advisers that disclosed
matters that may have constituted a triggering event under Rule 506(d).
Looking at the cases and the regulatory and court actions involved,
we determined whether the reported sanctions would constitute
triggering events under Rule 506(d). Most of the sanctions would not
because the criteria for providing disclosure reporting pages for Form
ADV include many events that do not constitute bad actor triggering
events under new Rule 506(d). For example, we excluded cases that were
initiated by a foreign court or regulator, cases that involved an
affiliate firm or cases that involved an individual employee of an
affiliate who is not a control person in the parent advisory firm. We
also excluded cases where a sanction fell outside the relevant look-
back period, such as a Commission cease-and-desist order that is more
than five years old. In addition, we excluded cases in which an action
did not meet the relevant substantive criteria, such as Commission
cease-and-desist orders for violations other than Section 5 of the
Securities Act or a scienter-based anti-fraud provision, or felonies
that were unrelated to the criteria of Rule 506(d), such as traffic
violations.
After these exclusions, we found that approximately 1% of reporting
investment advisers associated with pooled investment funds reported
bad actor triggering events in their 2012 Form ADV. The results of our
analysis are presented in the table below.\303\
---------------------------------------------------------------------------
\303\ Note that since an investment adviser can be subject a
combination of criminal, regulatory and civil sanctions, the sum of
the three categories of sanctions may exceed the number of
investment advisers that are subject to sanctions.
------------------------------------------------------------------------
Number of
investment
advisers
------------------------------------------------------------------------
Total investment advisers................................... 13,173
Investment advisers advising pooled investment funds........ 7,772
Pooled investment fund investment advisers with disclosure 435
reporting pages............................................
Pooled investment fund investment advisers subject to final 384
orders.....................................................
Pooled investment fund investment advisers with `bad actor' 48
triggering events..........................................
Criminal sanctions.......................................... 1
Regulatory sanctions........................................ 42
Civil sanctions............................................. 11
------------------------------------------------------------------------
Analysis of Costs and Benefits. Investment managers play a
significant role in the management of pooled investment funds. We have
included them in the definition of covered persons so that entities or
individuals that exercise control over fund management are subject to
bad actor disqualification under Rule 506(d). It will therefore provide
consistency for covering `control persons' of both pooled investment
fund issuers and issuers that are not pooled investment funds.
Additional issuer costs arising from the addition of investment
managers as covered persons will arise from conducting factual
inquiries and, in some cases, restructuring governance and control
arrangements, preparing disclosure or obtaining waivers from
disqualification for having an investment adviser with a history of bad
acting. Our analysis shows that the incidence of disqualifying events
is low (less than 1%) for investment advisers. So their inclusion in
the list of covered persons should not be generally burdensome for
issuers. On the other hand, covering investment managers directly will
obviate the need for issuers to conduct a fact-intensive inquiry to
determine whether an investment manager would be regarded as a de facto
director or executive officer of a pooled investment fund, or as a
promoter of such fund. As a result, the additional costs from this new
category of covered person are not likely to be high.
Narrower Coverage of Officers of Issuers and Financial
Intermediaries. Some commenters raised concerns that the compliance
costs associated with monitoring a potentially large class of covered
persons may be high.\304\ The rules we are adopting limit the pool of
covered persons by covering only executive officers and officers
participating in the offering, rather than all officers, of issuers,
underwriters, compensated solicitors and investment managers of pooled
investment funds. This should reduce compliance costs by limiting
covered persons to a more manageable number who should generally be
easier to identify. It should also reduce or eliminate costs, such as
lost employment opportunities, for individuals who are subject to
potentially disqualifying events but are not executive officers of
issuers, compensated solicitors or investment managers to pooled
investment fund issuers and are not personally involved in Rule 506
offerings. We do not believe it will significantly compromise the
intended investor protection benefits of the rule, because all officers
performing policy-making functions or personally involved with the
offering will be covered.
---------------------------------------------------------------------------
\304\ See comment letters from SIFMA; NYCBA; Five Firms; S&C.
---------------------------------------------------------------------------
No Disqualification Where the Relevant Regulatory Authority Advises
[[Page 44768]]
That Disqualification is Not Warranted. The amendments we are adopting
include a provision under which disqualification will not arise if a
state or federal regulator issuing an order advises in writing that
Rule 506 disqualification is not necessary under the circumstances. We
believe this provision will create cost savings for affected covered
persons such as issuers, individuals and compensated solicitors by
eliminating the need to seek waivers from the Commission or pursue
other means of raising capital. We expect that some issuers and other
covered persons will adjust their settlement negotiations to bargain
for an express determination that disqualification from Rule 506 is
unnecessary.\305\ As the provision applies only where state or federal
regulators have determined that Rule 506 disqualification is not
necessary, we do not believe it is likely to impair the intended
investor protection benefits of the bad actor disqualification scheme.
---------------------------------------------------------------------------
\305\ See Rule 506(d)(2)(iii).
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V. Final Regulatory Flexibility Act Analysis
This final regulatory flexibility analysis has been prepared in
accordance with 5 U.S.C. 603. It relates to amendments to Rule 506 of
Regulation D under the Securities Act that disqualify certain offerings
where ``felons and other `bad actors''' are participating or present
from relying on Rule 506 for an exemption from registration under the
Securities Act, or impose disclosure requirements in respect of such
offerings.
A. Reasons for, and Objectives of, the Action
The primary reason for the amendments is to implement the
requirements of Section 926 of the Dodd-Frank Act. Section 926 requires
the Commission to issue rules under which certain offerings where
``felons and other `bad actors''' are participating or present will be
disqualified from reliance on Rule 506 under Regulation D for an
exemption from registration under the Securities Act. Under the
amendments adopted today, offerings will be disqualified for triggering
events that occur after the effective date of the amendments, and
disclosure to investors will be required in respect of triggering
events that occur before the effective date.
Our primary objective is to implement the requirements of Section
926 of the Dodd-Frank Act. In general, the rule we are adopting
implements the statutory requirements. We have included a ``reasonable
care'' exception in the final amendments, which we believe will make
the rule easier for issuers to use, and should encourage continued use
of Rule 506 over exempt transactions outside of Rule 506. We have also
added an additional disqualifying event for certain Commission cease-
and-desist orders, which we believe will make the overall regulatory
scheme more consistent and will increase the investor protection
benefits of the amendments. We are requiring disclosure, rather than
disqualification, for triggering events occurring before effectiveness
of the final amendments as a means of enhancing protection of investors
participating in offerings involving bad actors, without giving rise to
the fairness and other concerns associated with applying the new
disqualification provisions in respect of preexisting events.
B. Significant Issues Raised by Public Comment
In the proposing release, we requested comment on every aspect of
the initial regulatory flexibility analysis (``IRFA''), including the
number of small entities that would be affected by the proposed
amendments, the nature of the impact, how to quantify the number of
small entities that would be affected, and how to quantify the impact
of the proposed amendments. We did not receive comments specifically
addressing the IRFA. One commenter suggested exempting offerings below
a certain size from the new disqualification provisions based on
concerns about the cost of Securities Act registration if Rule 506 were
unavailable,\306\ but we do not believe that would be consistent with
the requirements of Section 926 of the Dodd-Frank Act.
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\306\ See comment letter from Burningham.
---------------------------------------------------------------------------
C. Small Entities Subject to the Rule Amendments
The amendments will affect issuers (including both operating
businesses and investment funds that raise capital under Rule 506) and
other covered persons, such as financial intermediaries, that are small
entities. For purposes of the Regulatory Flexibility Act under our
rules, an entity is a ``small business'' or ``small organization'' if
it has total assets of $5 million or less as of the end of its most
recent fiscal year and is engaged or proposing to engage in an offering
of securities that does not exceed $5 million.\307\ For purposes of the
Regulatory Flexibility Act, an investment company is a small entity if
it, together with other investment companies in the same group of
related investment companies, has net assets of $50 million or less as
of the end of its most recent fiscal year.
---------------------------------------------------------------------------
\307\ 17 CFR 230.157.
---------------------------------------------------------------------------
The final amendments will apply to all issuers that conduct
offerings under Rule 506 and will affect small issuers (including both
operating businesses and pooled investment funds that raise capital
under Rule 506) relying on this exemption from Securities Act
registration. All issuers that sell securities in reliance on
Regulation D are required to file a Form D with the Commission
reporting the transaction. For the year ended December 31, 2012, 16,067
issuers made 18,187 new Form D filings, of which 15,208 relied on the
Rule 506 exemption. Based on information reported by issuers on Form D,
there were 3,958 small issuers \308\ relying on the Rule 506 exemption
in 2012. This number likely underestimates the actual number of small
issuers relying on the Rule 506 exemption, however, because over 50% of
issuers declined to report their size.
---------------------------------------------------------------------------
\308\ Of this number, 3,627 of these issuers are not investment
companies, and 331 are investment companies. We also note that
issuers that are not investment companies disclose only revenues on
Form D, and not total assets. Hence, we use the amount of revenues
as a measure of issuer size.
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D. Reporting, Recordkeeping and Other Compliance Requirements
The final amendments will impose a disclosure requirement with
respect to triggering events that occurred before the effective date of
the new disqualification provisions and would have triggered
disqualification had they occurred after that date.\309\ Such
disclosure must be in writing and furnished to each purchaser a
reasonable time prior to sale. There is no prescribed form that such
disclosure must take.
---------------------------------------------------------------------------
\309\ As discussed in Part II.G of this Release, we are also
changing the form of the signature block of Form D.
---------------------------------------------------------------------------
In addition, we expect that issuers will exercise reasonable care
to ascertain whether a disqualification exists with respect to any
covered person, and document their exercise of reasonable care. The
steps required will vary with the circumstances, but we anticipate
would generally include making factual inquiry of covered persons and,
where the issuer has reason to question the veracity or completeness of
responses to such inquiries, further steps such as reviewing
information on publicly available databases. In addition, issuers will
have to prepare any necessary disclosure regarding preexisting events.
[[Page 44769]]
We expect that the costs of compliance would generally be lower for
small entities than for larger ones because of the relative simplicity
of their organizational structures and securities offerings and the
generally smaller numbers of individuals and entities involved.
E. Duplicative, Overlapping or Conflicting Federal Rules
The Commission believes that there are no rules that duplicate,
overlap or conflict with the final amendments to Rules 145, 147, 152
and 155; Rules 501 and 506 of Regulation D; and Form D under the
Securities Act and to Rule 30-1 of our Rules of Organization and
Program Management.
F. Significant Alternatives
The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish the stated objectives of our
amendments, while minimizing any significant adverse impact on small
entities. In connection with the final amendments, we considered the
following alternatives:
The establishment of different compliance or reporting
requirements or timetables that take into account the resources
available to small entities;
The clarification, consolidation, or simplification of the
rule's compliance and reporting requirements for small entities;
The use of performance rather than design standards; and
An exemption from coverage of the amendments, or any part
thereof, for small entities.
With respect to the establishment of different compliance
requirements or timetables under our final amendments for small
entities, we do not think this is feasible or appropriate. The
amendments are designed to exclude ``felons and other `bad actors' ''
from involvement in Rule 506 securities offerings, which could benefit
small issuers by protecting them and their investors from bad actors
and increasing investor trust in such offerings. Increased investor
trust could reduce the cost of capital and create greater opportunities
for small businesses to raise capital.
Likewise, with respect to potentially clarifying, consolidating, or
simplifying compliance and reporting requirements, the amendments do
not impose any new reporting requirements. To the extent they may be
considered to create a new compliance requirement to exercise
reasonable care to ascertain whether a disqualification exists with
respect to any offering and to furnish a written description of
preexisting triggering events, the precise steps necessary to meet that
requirement will vary according to the circumstances. In general, we
believe the requirement will more easily be met by small entities than
by larger ones because we believe that their structures and securities
offerings are generally less complex and involve fewer participants.
With respect to using performance rather than design standards, we
note that the ``reasonable care'' exception is a performance standard.
With respect to exempting small entities from coverage of these
final amendments, we believe such an approach would be impracticable
and contrary to the requirements of Section 926. Regulation D was
designed, in part, to provide exemptive relief for smaller issuers.
Exempting small entities from bad actor provisions could result in a
decrease in investor protection and trust in the private placement and
small offerings markets, which would be contrary to the legislative
intent of Section 926. We have endeavored to minimize the regulatory
burden on all issuers, including small entities, while meeting our
regulatory objectives, and have included a ``reasonable care''
exception and waiver authority for the Commission to give issuers and
other covered persons additional flexibility with respect to the
application of these amendments.
VI. Statutory Authority and Text of Amendments
We are adopting the amendments to 17 CFR Parts 230 and 239
contained in this document under the authority set forth in Sections
4(a)(2), 19 and 28 of the Securities Act, as amended,\310\ and Section
926 of the Dodd-Frank Act.\311\ We are adopting the amendments to 17
CFR Part 200 contained in this document under the authority of Sections
4A and 4B of the Securities Exchange Act of 1934.\312\
---------------------------------------------------------------------------
\310\ 15 U.S.C. 77d(a)(2), 77s and 77z-3.
\311\ 15 U.S.C. 77d note. Although Pub. L. No. 112-106, sec.
201(a), 126 Stat. 313 (2012) is not an authority for the amendments
in this release, it is being included in the instruction below for
the general authority citation for Part 230 to ensure that the Code
of Federal Regulations is correctly updated for purposes of the
final rule also published today.
\312\ 15 U.S.C. 78d-1, 78d-2.
---------------------------------------------------------------------------
List of Subjects
17 CFR Part 200
Administrative practice and procedure, Authority delegations
(Government agencies), Organization and functions (Government
agencies), Reporting and recordkeeping requirements.
17 CFR Parts 230 and 239
Reporting and recordkeeping requirements, Securities.
For the reasons set out above, Title 17, Chapter II of the Code of
Federal Regulations is hereby amended as follows:
PART 200--ORGANIZATION; CONDUCT AND ETHICS; AND INFORMATION AND
REQUESTS
0
1. The general authority citation for Part 200, Subpart A, continues to
read, in part, as follows and the sectional authority for Sec. 200.312
is removed.
Authority: 15 U.S.C. 77o, 77s, 77sss, 78d, 78d-1, 78d-2, 78w,
78ll (d), 78mm, 80a-37, 80b-11, and 7202, unless otherwise noted.
* * * * *
0
2. Section 200.30-1(c) is revised to read as follows:
Sec. 200.30-1 Delegation of authority to Director of Division of
Corporation Finance.
* * * * *
(c) With respect to the Securities Act of 1933 (15 U.S.C. 77a et
seq.) and Regulation D thereunder (Sec. Sec. 230.500 through 230.508
of this chapter), to authorize the granting of applications under
Sec. Sec. 230.505(b)(2)(iii)(C), 230.506(d)(2)(ii), and 230.507(b) of
this chapter upon the showing of good cause that it is not necessary
under the circumstances that the exemption under Regulation D be
denied.
* * * * *
PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933
0
3. The general authority citation for Part 230 is revised to read as
follows:
Authority: 15 U.S.C. 77b, 77b note, 77c, 77d, 77d note, 77f,
77g, 77h, 77j, 77r, 77s, 77z-3, 77sss, 78c, 78d, 78j, 78l, 78m, 78n,
78o, 78o-7 note, 78t, 78w, 78ll(d), 78mm, 80a-8, 80a-24, 80a-28,
80a-29, 80a-30, and 80a-37, and Pub. L. No. 112-106, Sec. 201(a),
126 Stat. 313 (2012), unless otherwise noted.
* * * * *
0
4. Amend Sec. 230.145 by:
0
a. Removing the reference to ``and 4(2)'' in the second paragraph of
the Preliminary Note and adding in its place ``and 4(a)(2)'';
0
b. Removing Note 1 and Note 2 following the introductory text; and
0
c. Revising the introductory text following the Preliminary Note to
read as follows:
Sec. 230.145 Reclassification of securities, mergers, consolidations
and acquisitions of assets.
* * * * *
[[Page 44770]]
Transactions for which statutory exemptions under the Act,
including those contained in sections 3(a)(9), (10), (11) and 4(2), are
otherwise available are not affected by Rule 145. Reference is made to
Rule 153a (Sec. 230.153a of this chapter) describing the prospectus
delivery required in a transaction of the type referred to in Rule 145.
A reclassification of securities covered by Rule 145 would be exempt
from registration pursuant to section 3(a)(9) or (11) of the Act if the
conditions of either of these sections are satisfied.
* * * * *
0
5. Amend Sec. 230.147(b)(2) by removing the reference to ``section
4(2)'' and adding in its place ``section 4(a)(2)''.
0
6. Amend Sec. 230.152 by removing the reference to ``section 4(2)''
and adding in its place ``section 4(a)(2)''.
0
7. Amend Sec. 230.155 by removing the phrase ``Preliminary Note:'' and
redesignating that note as the introductory text, and removing the
reference to ``section 4(2)'' from paragraph (a) and adding in its
place ``section 4(a)(2)''.
0
8. Amend Sec. 230.501 by:
0
a. Redesignating paragraphs (g) and (h) as paragraphs (h) and (i),
respectively, and adding new paragraph (g); and
0
b. Redesignating Notes 1, 2, and 3 at the end of the section as Note 1
to Sec. 230.501, Note 2 to Sec. 230.501, and Note 3 to Sec. 230.501,
respectively.
The addition reads as follows:
Sec. 230.501 Definitions and terms used in Regulation D.
* * * * *
(g) Final order. Final order shall mean a written directive or
declaratory statement issued by a federal or state agency described in
Sec. 230.506(d)(1)(iii) under applicable statutory authority that
provides for notice and an opportunity for hearing, which constitutes a
final disposition or action by that federal or state agency.
* * * * *
0
9. Amend Sec. 230.506 by:
0
a. Redesignating the Note following paragraph (b)(2)(i) as ``Note to
paragraph (b)(2)(i)'';
0
b. Adding and reserving paragraph (c); and
0
c. Adding paragraphs (d) and (e).
The additions read as follows:
Sec. 230.506 Exemption for limited offers and sales without regard to
dollar amount of offering.
* * * * *
(c) [Reserved]
(d) ``Bad Actor'' disqualification. (1) No exemption under this
section shall be available for a sale of securities if the issuer; any
predecessor of the issuer; any affiliated issuer; any director,
executive officer, other officer participating in the offering, general
partner or managing member of the issuer; any beneficial owner of 20%
or more of the issuer's outstanding voting equity securities,
calculated on the basis of voting power; any promoter connected with
the issuer in any capacity at the time of such sale; any investment
manager of an issuer that is a pooled investment fund; any person that
has been or will be paid (directly or indirectly) remuneration for
solicitation of purchasers in connection with such sale of securities;
any general partner or managing member of any such investment manager
or solicitor; or any director, executive officer or other officer
participating in the offering of any such investment manager or
solicitor or general partner or managing member of such investment
manager or solicitor:
(i) Has been convicted, within ten years before such sale (or five
years, in the case of issuers, their predecessors and affiliated
issuers), of any felony or misdemeanor:
(A) In connection with the purchase or sale of any security;
(B) Involving the making of any false filing with the Commission;
or
(C) Arising out of the conduct of the business of an underwriter,
broker, dealer, municipal securities dealer, investment adviser or paid
solicitor of purchasers of securities;
(ii) Is subject to any order, judgment or decree of any court of
competent jurisdiction, entered within five years before such sale,
that, at the time of such sale, restrains or enjoins such person from
engaging or continuing to engage in any conduct or practice:
(A) In connection with the purchase or sale of any security;
(B) Involving the making of any false filing with the Commission;
or
(C) Arising out of the conduct of the business of an underwriter,
broker, dealer, municipal securities dealer, investment adviser or paid
solicitor of purchasers of securities;
(iii) Is subject to a final order of a state securities commission
(or an agency or officer of a state performing like functions); a state
authority that supervises or examines banks, savings associations, or
credit unions; a state insurance commission (or an agency or officer of
a state performing like functions); an appropriate federal banking
agency; the U.S. Commodity Futures Trading Commission; or the National
Credit Union Administration that:
(A) At the time of such sale, bars the person from:
(1) Association with an entity regulated by such commission,
authority, agency, or officer;
(2) Engaging in the business of securities, insurance or banking;
or
(3) Engaging in savings association or credit union activities; or
(B) Constitutes a final order based on a violation of any law or
regulation that prohibits fraudulent, manipulative, or deceptive
conduct entered within ten years before such sale;
(iv) Is subject to an order of the Commission entered pursuant to
section 15(b) or 15B(c) of the Securities Exchange Act of 1934 (15
U.S.C. 78o(b) or 78o-4(c)) or section 203(e) or (f) of the Investment
Advisers Act of 1940 (15 U.S.C. 80b-3(e) or (f)) that, at the time of
such sale:
(A) Suspends or revokes such person's registration as a broker,
dealer, municipal securities dealer or investment adviser;
(B) Places limitations on the activities, functions or operations
of such person; or
(C) Bars such person from being associated with any entity or from
participating in the offering of any penny stock;
(v) Is subject to any order of the Commission entered within five
years before such sale that, at the time of such sale, orders the
person to cease and desist from committing or causing a violation or
future violation of:
(A) Any scienter-based anti-fraud provision of the federal
securities laws, including without limitation section 17(a)(1) of the
Securities Act of 1933 (15 U.S.C. 77q(a)(1)), section 10(b) of the
Securities Exchange Act of 1934 (15 U.S.C. 78j(b)) and 17 CFR 240.10b-
5, section 15(c)(1) of the Securities Exchange Act of 1934 (15 U.S.C.
78o(c)(1)) and section 206(1) of the Investment Advisers Act of 1940
(15 U.S.C. 80b-6(1)), or any other rule or regulation thereunder; or
(B) Section 5 of the Securities Act of 1933 (15 U.S.C. 77e).
(vi) Is suspended or expelled from membership in, or suspended or
barred from association with a member of, a registered national
securities exchange or a registered national or affiliated securities
association for any act or omission to act constituting conduct
inconsistent with just and equitable principles of trade;
(vii) Has filed (as a registrant or issuer), or was or was named as
an underwriter in, any registration statement or Regulation A offering
statement filed with the Commission that, within five years before such
sale,
[[Page 44771]]
was the subject of a refusal order, stop order, or order suspending the
Regulation A exemption, or is, at the time of such sale, the subject of
an investigation or proceeding to determine whether a stop order or
suspension order should be issued; or
(viii) Is subject to a United States Postal Service false
representation order entered within five years before such sale, or is,
at the time of such sale, subject to a temporary restraining order or
preliminary injunction with respect to conduct alleged by the United
States Postal Service to constitute a scheme or device for obtaining
money or property through the mail by means of false representations.
(2) Paragraph (d)(1) of this section shall not apply:
(i) With respect to any conviction, order, judgment, decree,
suspension, expulsion or bar that occurred or was issued before
September 23, 2013;
(ii) Upon a showing of good cause and without prejudice to any
other action by the Commission, if the Commission determines that it is
not necessary under the circumstances that an exemption be denied;
(iii) If, before the relevant sale, the court or regulatory
authority that entered the relevant order, judgment or decree advises
in writing (whether contained in the relevant judgment, order or decree
or separately to the Commission or its staff) that disqualification
under paragraph (d)(1) of this section should not arise as a
consequence of such order, judgment or decree; or
(iv) If the issuer establishes that it did not know and, in the
exercise of reasonable care, could not have known that a
disqualification existed under paragraph (d)(1) of this section.
Instruction to paragraph (d)(2)(iv). An issuer will not be able to
establish that it has exercised reasonable care unless it has made, in
light of the circumstances, factual inquiry into whether any
disqualifications exist. The nature and scope of the factual inquiry
will vary based on the facts and circumstances concerning, among other
things, the issuer and the other offering participants.
(3) For purposes of paragraph (d)(1) of this section, events
relating to any affiliated issuer that occurred before the affiliation
arose will be not considered disqualifying if the affiliated entity is
not:
(i) In control of the issuer; or
(ii) Under common control with the issuer by a third party that was
in control of the affiliated entity at the time of such events.
(e) Disclosure of prior ``bad actor'' events. The issuer shall
furnish to each purchaser, a reasonable time prior to sale, a
description in writing of any matters that would have triggered
disqualification under paragraph (d)(1) of this section but occurred
before September 23, 2013. The failure to furnish such information
timely shall not prevent an issuer from relying on this section if the
issuer establishes that it did not know and, in the exercise of
reasonable care, could not have known of the existence of the
undisclosed matter or matters.
Instruction to paragraph (e). An issuer will not be able to
establish that it has exercised reasonable care unless it has made, in
light of the circumstances, factual inquiry into whether any
disqualifications exist. The nature and scope of the factual inquiry
will vary based on the facts and circumstances concerning, among other
things, the issuer and the other offering participants.
PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933
0
10. The authority citation for part 239 continues to read, in part, as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77sss, 78c, 78l, 78m, 78n, 78o(d), 78o-7 note, 78u-5, 78w(a), 78ll,
78mm, 80a-2(a), 80a-3, 80a-8, 80a-9, 80a-10, 80a-13, 80a-24, 80a-26,
80a-29, 80a-30, and 80a-37, unless otherwise noted.
* * * * *
0
11. Amend Form D (referenced in Sec. 239.500) by revising the third
indented paragraph under the heading ``Terms of Submission'' in the
``Signature and Submission'' section following Item 16 to read as
follows:
Certifying that, if the issuer is claiming a Regulation D exemption
for the offering, the issuer is not disqualified from relying on
Regulation D for one of the reasons stated in Rule 505(b)(2)(iii) or
Rule 506(d).
Note: The text of Form D does not, and the amendments will not,
appear in the Code of Federal Regulations.
By the Commission.
Dated: July 10, 2013.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2013-16983 Filed 7-23-13; 8:45 am]
BILLING CODE 8010-01-P