SEC 'bad actor' rules to impact PE hiring

Private equity firms may have to increase their due diligence on potential employees and placement agents after the Securities and Exchange Commission (SEC) last month adopted so-called 'bad actor' provisions, legal sources say.

The rules, first proposed in May 2011, disqualify private funds from using a 'safe harbor' available under Rule 506 of Regulation D of the Securities Act if any of the fund’s senior professionals, significant stakeholders or placement agents have been convicted of a felony or fraud in connection with the selling of securities.

Until now there has been no “issuer qualification” restricting use of the 506 exemption, which has become the preferred exemption for private placements. It has accounted for approximately 93 percent of private offerings under Regulation D, according to a client memo from Moses & Singer.

The rule, effective September 23, also has a retroactive element requiring GPs to provide investors with a written description of any past convictions that would have disqualified the firm under the new rules but occurred prior to the effective date. 

Legal sources say increased due diligence when hiring is necessary because incidents covered under the rules are fairly broad. Past court injunctions and restraining orders related to securities, false filings or disciplinary orders, as well as serious convictions all need to be reported. 

“This will certainly impact due diligence on employees and will also affect the contractual negotiations with service providers such as placement agents,” one US-based lawyer told PE Manager. “This type of background checking will presumably become de rigeur and certain people with chequered pasts will simply be shut out of the industry.”

The SEC suggests firms consider distributing “questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings” to staff and placement agents. GPs may also wish to add appropriate provisions to placement agent contracts, in case a placement agent becomes a 'bad actor' during an offering. 

“Indemnifications will be added to placement agent agreements ensuring the placement agent has screened all of their bad actors, because if the placement agent has a disqualifying bad actor, the risk will be on the GP who loses its private placement exemption,” explained a second US-based securities lawyer.