Effect of New Bad Actor Provisions on Regulation D Private Placements

Wall Street Stone EngravingThe private placement exemption included in Rule 506 of Regulation D is a commonly used method for raising capital. However, after the enactment of Dodd Frank, it now includes a “bad actor” disqualification provision that makes Rule 506 unavailable if the issuer has violated certain securities laws. (See SEC Release No. 33-9414.) Specifically, the disqualification bars issuers from relying on Reg. D to conduct a non-public securities offering for five years if the issuer or one of its associates is a so-called bad actor. This consequence can be costly and severely damaging. A bad actor is generally an issuer, director or executive officer who has been subject to a criminal conviction or court injunction relating to securities transactions, a final order of certain financial regulators, an SEC order revoking registration, an SEC cease-and desist order with respect to certain intent-based rules, or suspension or expulsion from a self-regulatory organization, among others.

The good news is that the SEC can waive the automatic disqualification upon a showing of good cause. (See 17 C.F.R. § 17.230(d)(2)(ii). The bad news is that while this rule may seem clear at first glance, neither the statute nor the SEC has clearly articulated the meaning of “good cause.” This ambiguity has divided SEC commissioners and left issuers and securities professionals in the dark. In addition, to date, the SEC decisions are mostly silent on what criteria were used to find the “good cause” that merited the grant of a waiver, which therefore makes it difficult to determine when an application for a waiver will be granted.

The SEC Division of Corporation Finance, which handles applications for waivers, recently described the factors it considers in waiver requests. A waiver, which may be comprehensive or conditional, may be granted “if a review of all facts and circumstances leads the Division to determine that the waiver applicant has met its burden to show good cause and that it is not necessary under the circumstances that the [Rule 506] exemptions be denied.”[1] Such facts and circumstances include consideration of the nature of the violation or conviction, whether it involved the offer and sale of securities, whether the conduct involved a criminal conviction or was an intent-based violation.[2] However, the Division’s recent clarification is arguably too vague to provide clear guidance.

Significantly for securities professionals, the waiver issue arises not just in matters addressed by the SEC, but can arise in the context of a FINRA enforcement proceeding. For example, a bad actor disqualification can be triggered by a suspension resulting from a FINRA enforcement action.

One of the problems that we see is that this “one size fits all” penalty, compounded by the lack of a clear definition of “good cause,” can impose severe penalties for relatively minor transgressions yet provide a waiver in a case involving huge regulatory violations. Compare, for example, a recent Hutner Klarish case where FINRA refused to consider extending a waiver in settling a case involving a relatively minor offense, with the SEC’s recent grant of a waiver in a case involving a bank that had at least thirty prior regulatory sanctions.[3]

A division of opinion between SEC Commissioners regarding the SEC waiver policy further complicates the situation. For example, Oppenheimer & Co. Inc. (a full-service broker-dealer) was recently granted a waiver by a Commission divided 3-2.[4] In a somewhat unusual step, the dissenters[5] openly stated their reasons for why a waiver should not have been granted to a bank with a repeated pattern of regulatory violations, a history seemingly ignored by the majority.

The Oppenheimer case and others like it have led to recent criticism by members of Congress, consumer advocates and other parties. Critics contend that the nation’s biggest banks enjoy special treatment, evidenced by the fact that they are often granted waivers. That said, in the last year and a half, the SEC has rejected fourteen bad actor waiver applications and granted thirteen. Thus, evidence of a clear pattern does not exist.

The issue of whether bad actor waivers will be granted is still in flux and its effect on Rule 506 private placements is unclear. If you are considering raising capital through a Rule 506 private placement, make sure to keep these issues in mind. We are here to help as this divisive topic is far from settled.

[1] “Waivers of Disqualification under Regulation A and Rules 505 and 506 of Regulation D,” Division of Corporation Finance, March 13, 2015, available at http://www.sec.gov/divisions/corpfin/guidance/disqualification-waivers.shtml. [2] Id[3] See Securities and Exchange Commission, In the Matter of Oppenheimer & Co., Inc., No. 3- 16361, “Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 15(b) and 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order” (Jan. 27, 2015). [4] Id[5] Commissioner Luis A. Aguilar and Commissioner Kara M. Stein, “Dissenting Statement In the Matter of Oppenheimer & Co., Inc.” (Feb. 4, 2015), available at http://www.sec.gov/news/statement/dissenting-statement-oppenheimer-inc.html#.VNZjGf7wvIU.