Good news on 'bad actors'

On December 4, 2013 and January 3, 2014, the staff of the US Securities and Exchange Commission (SE”) released additional “Compliance and Disclosure Interpretations” (or CDIs) that provide further guidance regarding the “bad actor” disqualification provisions of new Rule 506(d) (the “Bad Actor Rule”).

This Rule, which came into effect in September 2013, disqualifies offerings of securities involving certain “bad actors” from relying on the private placement exemption safe harbor in Rule 506 of Regulation D, the exemption from registration under the US Securities Act of 1933 on which a great many private funds rely.

The CDIs clarified several key aspects of the Bad Actor Rule that are relevant to private funds, including the following:

Portfolio companies are not “affiliated issuers”: Most significantly, the SEC staff has substantially narrowed the scope of the term “affiliated issuer.” An issuer may not rely on Rule 506 if an “affiliated issuer” has been subject to a one of the disqualifying events specified by the Bad Actor Rule. The Bad Actor Rule did not define the term “affiliated issuer,” however, which created substantial confusion as to the scope of the Rule, particularly with respect to private fund portfolio companies. If the term “affiliated issuer” were construed using the generally applicable definition of “affiliate,” the Bad Actor Rule would have an exceptionally broad reach.

Under this construction, a disciplinary event at a fund’s portfolio company would disqualify not only the portfolio company, but also the fund, affiliated funds and the portfolio companies that are under common control from relying on the Rule 506 safe harbor for their offerings. The SEC staff resolved this confusion by clarifying that an “affiliated issuer” is an affiliate that is issuing securities in the same offering as the issuer (including offerings subject to integration, as may be the case with certain feeder fund or parallel fund offerings and offerings by the main fund). This narrower construction should serve to reduce significantly the administrative burden of the Bad Actor Rule: sponsors no longer need to seek periodic certifications from portfolio companies and their subsidiaries as to whether those entities have experienced any disqualifying events.

Placement agents, curing disqualification: If a compensated solicitor (i.e., a placement agent) becomes subject to a disqualifying event while an offering is ongoing, the fund can “cure” the disqualification and continue to rely on Rule 506 if the agent’s engagement is terminated and the agent is not compensated for any sales made after the date of the disqualification. In addition, where the disqualifying event relates to specific covered persons of a placement agent (e.g., officers of the agent involved in the offering, or employees of the agent who receive compensation in respect of the offering), the disqualification may be cured if the affected persons are terminated or cease performing roles that make them covered persons. This guidance should be taken into account when negotiating termination and “fee tail” provisions of placement agent engagement letters.

Placement agents, disclosure: The SEC staff has clarified that pre-September 23, 2013 events with respect to an actively engaged placement agent must be disclosed to all investors, not just to the investors that were solicited by the placement agent. However, disclosure does not need to be provided with respect to placement agents that are no longer involved in the offering.  

Beneficial owners: The Bad Actor Rule includes as covered persons any beneficial owners of 20 percent or more of the issuer’s voting equity securities, although the Rule itself did not define beneficial ownership. The most recent guidance from the SEC staff has clarified that beneficial ownership for these purposes is determined in accordance with Rule 13d-3 of the US Securities Exchange Act of 1934 (i.e., the rule applicable to reporting under Schedules 13D and 13G).

Under this rule, a sponsor may need to “look through” investing entities to identify beneficial ownership. As a result, in some cases a 20 percent beneficial owner may exist even where no individual investor holds 20 percent of a fund’s interests (for example this may be the case where multiple investors share a common general partner or discretionary investment adviser). Fund sponsors should review their investor diligence procedures and forms of subscription documents for funds that are actively issuing securities to ensure that 20 percent beneficial owners (as determined pursuant to Rule 13d-3) are properly identified. 

Periodic diligence updates for continuous offerings: The recent SEC guidance confirms the principle that issuers involved in continuous offerings (as is typically the case for most private fund offerings) must update their factual inquiries into covered persons periodically, whether through bring-down certificates, questionnaires, negative consent letters or re-checking of public databases. However, the SEC did not suggest any recommended frequency or provide any further guidance on when independent diligence might be needed in addition to obtaining initial certifications. Therefore, the appropriate steps to be taken will continue to depend on the particular facts and circumstances. A number of fund sponsors have implemented procedures to obtain quarterly certifications (or annual certifications with quarterly reminders), combined with agreements by the certifying persons that they will update their most recent certifications if any changes occur.

Non-US bad acts: Confirming the position taken by the SEC in the original proposing release for the Bad Actor Rule, the recent SEC staff guidance clarifies that convictions, court orders and injunctions of non-US courts and regulatory orders issued by non-U. regulatory authorities do not trigger disqualification under Rule 506.  

Kenneth Berman is a partner in the Washington DC office of Debevoise & Plimpton. Alan Paley is a partner and Jonathan Adler is an associate in the firm’s New York office. A version of this article originally appeared in the fall 2013 issue of the Debevoise & Plimpton Private Equity Report.