Securing a Rule 506 Bad Actor Disqualification Waiver

Practical Law Article 7-591-3607 (Approx. 11 pages)

Securing a Rule 506 Bad Actor Disqualification Waiver

by Practical Law Corporate & Securities

Bad Actor Disqualification

Under Rule 506(d), the Rule 506 safe harbor is not available for an offering if any covered person (see Covered Persons) has a disqualifying event (see Disqualifying Events) in that person's past, unless a bad actor disqualification waiver is obtained. An issuer must determine if its offering is subject to bad actor disqualification at any time it is offering or selling securities in reliance on Rule 506 (Question 260.14, SEC Compliance and Disclosure Interpretations: Securities Act Rules (Securities Act Rules C&DIs)).

Covered Persons

Covered persons under Rule 506's bad actor disqualification provision include:

The issuer, including predecessors and "affiliated issuers." The term affiliated issuer includes only issuer affiliates that are issuing securities in the same offering, including offerings subject to integration with the offering (Question 260.16, Securities Act Rules C&DIs). Certain exceptions are available for events related to an affiliated issuer that occurred before it was affiliated with the issuer.
Directors, executive officers, other officers participating in the offering, general partners and managing members of the issuer.
Beneficial owners, as that term is defined in Rule 13d-3 under the Exchange Act, of at least 20% of the issuer's outstanding voting equity securities, calculated on the basis of voting power.
Any promoters connected with the issuer in any capacity at the time of the securities sale.
If the issuer is a pooled investment fund, any investment manager of the issuer.
Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of securities, whether or not that person is a registered broker-dealer or associated person (each, a compensated solicitor).
General partners or managing members of any such investment manager or compensated solicitor and any director, executive officer or other officer participating in the offering of any:
- such investment manager or compensated solicitor; or
- general partner or managing member of any such investment manager or compensated solicitor.

For additional guidance on these categories, see Practice Note, Section 4(a)(2) and Regulation D Private Placements: Bad Actors Disqualified from Relying on Safe Harbor.

Disqualifying Events

Disqualifying events under Rule 506's bad actor disqualification provision include that the covered person:

Has been convicted, within ten years before the sale of securities (or five years, in the case of the issuer, its predecessors and affiliated issuers), of any felony or misdemeanor:
- in connection with the purchase or sale of a security;
- involving the making of a false SEC filing; or
- arising out of the conduct of certain types of financial intermediaries.
Is subject to any order, judgment or decree of any court of competent jurisdiction, entered within five years before the sale of securities, that at the time of the sale restrains or enjoins the covered person from engaging or continuing to engage in any conduct or practice:
- in connection with the purchase or sale of a security;
- involving the making of a false SEC filing; or
- arising out of the conduct of certain types of financial intermediaries.
Is subject to a final order from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies, the CFTC or the National Credit Union Administration that:
- at the time of the sale of securities, bars the covered person from associating with an entity regulated by that regulator; 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.
Is subject, at the time of the sale, to an SEC order entered under certain provisions relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons.
Is subject to any order of the SEC, entered within five years of the sale of securities, that at the time of the sale of securities 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 Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 under the Exchange Act, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Investment Advisers Act of 1940 (Advisers Act) (note that not all SEC orders to cease and desist from violations of SEC rules under Exchange Act Section 10(b) are disqualifying events, and disqualification is triggered only by SEC orders to cease and desist from violations of scienter-based provisions of the federal securities laws, including scienter-based rules); or
- Section 5 of the Securities Act
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.
Has filed or was named as an underwriter in any registration statement or Regulation A offering statement filed with the SEC that, within five years of the sale of securities, was the subject of a refusal order, stop order or order suspending the Regulation A exemption, or is, at the time of the sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued.
Is subject to a US Postal Service false representation order entered within five years of the sale of securities, or is, at the time of the sale, subject to a temporary restraining order or preliminary injunction regarding conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money through the mail by means of false representation.

Look-back periods in the rule are measured from the date of conviction or sanction, not from the date of the related conduct.

For additional discussion of these disqualifying events, see Practice Note, Section 4(a)(2) and Regulation D Private Placements: Bad Actors Disqualified from Relying on Safe Harbor.

Disqualification is not triggered by actions taken in jurisdictions other than the US, such as convictions, court orders or injunctions in a non-US court or regulatory orders issued by non-US regulatory authorities (Question 260.20, Securities Act Rules C&DIs). There are also certain exceptions from disqualification, including if:

Any disqualifying event occurred before September 23, 2013 (Rule 506(d)(2)(i)). However, under Rule 506(e) the issuer must disclose in writing any disqualifying events that occurred before September 23, 2013 to all prospective purchasers in the offering a reasonable time before completing the sale. This disclosure obligation is not subject to waiver (Question 260.24, Securities Act Rules C&DIs). For further guidance on the Rule 506(e) disclosure requirement, see Practice Note, Section 4(a)(2) and Regulation D Private Placements: Bad Actors Disqualified from Relying on Safe Harbor.
The court or other authority that issued the order, injunction or decree indicates or advises the SEC that it should not constitute a Rule 506(d) disqualifying event (Rule 506(d)(2)(iii)). In those cases, no separate waiver from the SEC needs to be sought and no other action is needed to confirm that the bad actor disqualification will not apply as a result of the order (Question 260.22, Securities Act Rules C&DIs).
An issuer can prove that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. To satisfy this burden, the issuer must show that it conducted a factual inquiry tailored to the facts and circumstances of the particular offering and its participants (Rule 506(d)(2)(iv)).

Requirements for Rule 506 Bad Actor Waiver

Rule 506 permits the SEC to waive bad actor disqualification on a showing of good cause that the disqualification is not necessary under the circumstances (Rule 506(d)(2)(ii)). SEC guidance suggests that certain circumstances may make it particularly likely that a waiver request will be granted, including:

A disqualified entity has experienced a change of control or supervisory personnel, and as a result the persons responsible for the conduct that the disqualifying event was premised on are no longer employed by, or exercise influence over, that disqualified entity.
The disqualifying order, judgment or decree was issued without the disqualified entity having notice or the opportunity for a hearing. This applies, for example, to a temporary injunction or restraining order issued on an ex parte basis without prior notice to the defendant.
The disqualifying event is an order by a regulator that permanently bars the disqualified person from associating with certain regulated entities or engaging in certain financial industry activities, and, while the disqualified person has no intention of violating that order, that person does wish to participate in a Rule 506 offering in another capacity (for example, it serves as a director of an issuer).

(See SEC Release No. 33-9414.)

In the rulemaking process for Rule 506(d), the SEC had considered whether each of these circumstances should be carved out of the disqualification provision altogether. Under the final rule, however, these circumstances trigger disqualification, and the adopting release suggests impacted parties use the waiver process.

SEC guidance states that additional factors may also be relevant to the staff's consideration of waiver requests in particular circumstances (see SEC Release No. 33-9414). According to the SEC's website, successful past waiver requests may provide guidance on factors that contribute to a showing of good cause (see SEC: Process for Requesting Waivers of "Bad Actor" Disqualification Under Rule 262 of Regulation A and Rules 505 and 506 of Regulation D).

Staff no-action letters issued in response to successful requests for bad actor disqualification waivers are available on the SEC's website. SEC orders granting waiver requests are also available on a separate page of the SEC's website, with the related waiver requests available on another page. For a chart listing, and giving certain information on, successful waiver requests, see Box, Rule 506 Bad Actor Waivers Chart.

Waiver Request Process

The SEC has delegated authority to grant Rule 506 bad actor disqualification waivers to the Director of its Division of Corporation Finance. The director has, in turn, subdelegated that authority to certain officials of the division, including the Chief of the Division's Office of Small Business Policy. That position is currently held by Mr. Sebastian Gomez Abero.

Despite the fact it has delegated bad actor waiver authority, the SEC itself may grant waivers directly. The SEC has done so on a number of occasions since Rule 506's bad actor disqualification provision became effective, presumably because there was some controversy surrounding certain waiver requests. When a waiver is granted pursuant to delegated authority, it is granted in a staff no-action letter. The SEC issues an order when granting a bad actor waiver directly (for examples of both types of waiver, see Box, Rule 506 Bad Actor Waivers Chart).

Waiver requests should be sent to the attention of Sebastian Gomez Abero, Chief, Office of Small Business Policy, Division of Corporation Finance, U.S. Securities and Exchange Commission. They may be e-mailed to [email protected] or addressed to:

Sebastian Gomez Abero, Chief

Office of Small Business Policy

Division of Corporation Finance

U.S. Securities and Exchange Commission

100 F Street, N.E. Washington, DC 20549-3628

(See SEC: Process for Requesting Waivers of "Bad Actor" Disqualification Under Rule 262 of Regulation A and Rules 505 and 506 of Regulation D.)

Waiver requests are often submitted by counsel on behalf of the requesting party. In many cases, both the waiver request and the responsive no-action letter or SEC order are dated the same day as the SEC action constituting the requesting party's disqualifying event. Companies often simultaneously, and in the same document, request waivers of bad actor disqualification under Rule 506, Rule 505 and Rule 262.

The SEC itself and staff operating under delegated authority have granted a number of bad actor disqualification waivers since Rule 506(d) became effective in September 2013. Waivers of bad actor disqualification granted so far have, for the most part, not imposed any specific conditions on the requesting party. Several have included the express condition that the requesting party provide written disclosure to investors of the relevant disqualifying event for five years. One request was granted subject to detailed conditions, and for a limited time period, subject to the requester's ability to ask for a longer waiver at the end of the initial waiver period. For more information on successful waiver requests, see Box, Rule 506 Bad Actor Waivers Chart.

In remarks to a committee of the Business Law Section of the American Bar Association, an SEC staff member explained that the staff posts only successful waiver requests to its website. According to that staff member, if the staff plans to deny a waiver request, it contacts the party that submitted the request and offers it the opportunity to withdraw the request instead of receiving a denial.

Form and Content of Successful Waiver Requests

Successful waiver requests follow a common outline that includes:

Introductory language requesting a waiver of disqualification on behalf of the disqualified party and identifying the disqualifying event.
Background on the disqualifying event and the alleged conduct it was premised on.
A list and discussion of the facts and circumstances the requester believes show good case that disqualification is unnecessary.

The third section of a waiver request is typically the most substantial. Among other things, requesters have cited the following facts and circumstances in support of their waiver requests:

The requester has taken steps to address the conduct the disqualifying event was premised on, such as:
- revising its written policies and procedures and supervisory system;
- implementing enhancements to controls and due diligence protocols;
- terminating employees responsible for misconduct and replacing other employees;
- restating its financial statements and remediating material weaknesses in internal control; and
- complying with any specific requirements of SEC orders related to the disqualifying event, such as engaging a qualified consultant to assist it in developing and implementing compliance policies and procedures.
Disqualification would adversely affect the requester's operations severely or disproportionately to the conduct the disqualifying event was premised on. In making this point, requesters have:
- detailed the fines and penalties that they have already agreed to pay and other remedial actions they have agreed to take as part of a negotiated settlement with the SEC concerning the conduct; and
- stated that participation in Rule 506 offerings in an integral part of their business strategies.
The conduct the disqualifying event was premised on did not relate to Regulation D offerings, or to securities offerings generally (for example, it was an alleged violation of broker-dealer registration or policies and procedures requirements).
The conduct the disqualifying event was premised on was not intentional, was not scienter-based or was not criminal in nature.
The disqualifying event arose out of a one-off violation, or the conduct the disqualifying event was premised on involved a small number of employees, was limited to a short time period or occurred many years ago.
The requester no longer engages in the line of business implicated in the conduct the disqualifying event was premised on, or the entity where the conduct occurred has recently been dormant.
The conduct the disqualifying event was premised on was carried out by an affiliate of the requester, or no current directors, officers or employees of the requester were involved in misconduct.
Disqualification would adversely affect third parties, such as parties that retain the requester to provide services related to transactions that may rely on Rule 506. Examples of third parties identified include:
- stockholders or other investors of the requester that might benefit from the requester having access to Rule 506 capital-raising opportunities;
- corporate issuers that have retained the requester to act as placement agent in Rule 506 offerings;
- pooled investment funds for which the requester acts as placement agent;
- high-net-worth and institutional customers of the requester to whom the requester offers access to Rule 506 offerings;
- trusts for which the requester serves as fiduciary and must make available a full range of investments, including securities offered in Rule 506 offerings; and
- global depositary receipts programs on which affiliates of the requester act as depositary bank.

For a chart including additional information on recent successful Rule 506 bad actor disqualification waiver requests, see Box, Rule 506 Bad Actor Waivers Chart.

Featured Resources on Rule 506 and Bad Actor Disqualification

Practical Law is featuring the following resources that can help attorneys understand Rule 506's bad actor disqualification provision and perform the diligence necessary to ensure any potential transaction roadblocks caused by bad actor disqualification are identified in a timely fashion:

Our Practice Note, Section 4(a)(2) and Regulation D Private Placements provides an overview of the registration exemptions available to issuers conducting private placements under Section 4(a)(2) of the Securities Act and Regulation D. It includes a detailed discussion of Rule 506(d), including SEC guidance on the bad actor disqualification provision.
Our Standard Document, Bad Actor Questionnaire is a standard form questionnaire for obtaining information from persons covered by Rule 506(d)'s bad actor disqualification provision.
Our Standard Clause, Bad Actor (Rule 506(d)) Disqualification Representations and Covenants is a set of standard representations, warranties and covenants related to bad actor disqualification that can be inserted into a placement agency agreement, distribution agreement or other similar agreement for an offering of securities in reliance on Rule 506.

Rule 506 Bad Actor Waivers Chart

Requester	Disqualifying Event	Specified Conditions	Waiver/Date
RBS Securities Inc.	Final judgment of federal court relating to alleged violations of Sections 17(a)(2) and (3) of the Securities Act related to alleged misstatements in a 2007 offering of residential mortgage-backed securities (RMBS).	Provide written disclosure to investors of disqualifying event for five years.	No-action Letter and Waiver Request (Nov. 25, 2013)
Instinet, LLC	SEC order under Section 15(b) of the Exchange Act and Section 203(k) of the Advisers Act alleging violations related to "soft dollar" payments.	Provide written disclosure to investors of disqualifying event for five years.	No-action Letter and Waiver Request (Dec. 26, 2013)
Credit Suisse Group AG	SEC order under Sections 15(b)(4) and 21C of the Exchange Act and Section 203(e) and (k) of the Advisers Act finding violations relating to the provision of cross-border brokerage and investment advisory services to certain US clients without registration as a broker-dealer or investment adviser.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	No-action Letter and Waiver Request (Feb. 21, 2014)
Certain Current Funds, Third Party Issuers Affiliated with Credit Suisse AG	Guilty plea entered in federal court related to a plea agreement between an affiliate of the requesters and the *Department of Justice* resolving charges of conspiracy to commit tax fraud related to accounts that affiliate established for cross-border clients.	Waiver is limited to disqualification under Rule 506(d)(1)(i) (disqualification due to a covered person's convictions, within ten/five years before a Rule 506 sale, of certain felonies or misdemeanors). Requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	SEC Order (May 19, 2014) Waiver Request (May 19, 2014)
Diamond Foods, Inc.	Final judgment of federal court related to alleged violations of Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A) and (B) of the Exchange Act and related rules related to alleged underreporting of payments to suppliers resulting in restatement of requester’s financial statements.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	No-action Letter and Waiver Request (Mar. 6, 2014)
Jefferies LLC	SEC order under Section 15(b)(4) resolving allegations that the requester failed reasonably to supervise a mortgage-backed securities trader alleged to have mislead counterparties, and other employees alleged to have engaged in misconduct.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	No-action Letter and Waiver Request (Mar. 12, 2014)
Dominick & Dominick LLC	SEC order finding violations of Sections 206(2), 206(3) and 206(4) of the Advisers Act and Rule 206(4)-7 under the Advisers Act relating to: The requester's obligation to ensure customers were receiving best execution. Disclosures in Form ADV. Failure to obtain consent before completing principal transactions.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	SEC Order (July 28, 2014) Waiver Request (July 23, 2014)
Citigroup Global Markets, Inc.	Final judgment of federal court relating to alleged violations of Sections 17(a)(2) and (3) of the Securities Act based on materially misleading marketing materials for CDO transactions.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	SEC Order (Sept. 26, 2014) Waiver Request (Aug. 22, 2014)
Wells Fargo Advisors, LLC	SEC order finding violations of Sections 15(g), 17(a) and 17(b) of the Exchange Act and Rule 17a-4(j) under the Exchange Act and Section 204A and 204(a) of the Advisers Act related to the requester's failure to adequately establish, maintain and enforce policies and procedures reasonably designed to prevent misuse of material nonpublic information.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	SEC Order (Sept. 22, 2014) Waiver Request (Sept. 22, 2014)
Barclays Capital Inc.	SEC order finding violations of Sections 204(a), 206(2), 206(3), 206(4) and 207 of the Advisers Act and certain related rules related to: The requester's failure to adequately enhance its infrastructure and adopt written policies and procedures as part of its integration of Lehman Brothers Inc.’s advisory business into its existing business. Other deficiencies, such as execution of principal transactions without disclosure or consent and violations of custody provisions.	None, but requester represented in waiver request that it will provide written disclosure to investors of disqualifying event for five years.	SEC Order (Sept. 23, 2014) Waiver Request (Sept. 23, 2014)
Bank of America, N.A. and Merrill Lynch, Pierce, Fenner & Smith, Inc.	Final judgment of federal court relating to alleged violations of Sections 17(a)(2) and (3) and Section 5(b)(1) of the Securities Act related to alleged failures to comply with representations, misleading disclosure and the provision of misleading documents to investors and rating agency in RMBS offerings.	Waiver applies for a period of 30 months (half the time of a five-year disqualification) and is subject to eight specific conditions. The conditions include, among others, the requester: Retaining an independent consultant to conduct a review of its policies and procedures for Rule 506 compliance. Requiring the consultant to submit a written review report. Implementing all the recommendations contained in the report or obtaining SEC consent to alternatives. The waiver allows the requester to apply to the SEC for an additional 30 month waiver after it has implemented all of the independent consultant's recommendations.	SEC Order (November 25, 2014) Waiver Request (November 18, 2014)

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