The following comes to us from Christopher L. Doerksen, a partner at Dorsey & Whitney LLP in Seattle.

For years, issuers and broker-dealers have relied upon Rule 506 of Regulation D under the Securities Act of 1933, as amended (the “Act”), as a workhorse in allowing issuers to raise capital from accredited investors and others without filing a registration statement with the Securities and Exchange Commission (the “SEC”). Effective September 23, 2013, new SEC rules make the exemption unavailable if the issuer, the selling broker-dealer or certain related persons have been the subject of certain “bad actor” disqualifying events. In this corporate update, we summarize the new rules and provide our recommendations to issuers and broker-dealers to ensure they remain eligible to offer and sell securities in reliance upon the Rule 506 exemption.

The final release can be found here.

“Bad Actor” Disqualification

Under the new disqualification rules, an issuer will be ineligible to rely on the Rule 506 exemption if certain convictions, orders, judgments or other adverse actions with respect to U.S. governmental authorities or U.S. self-regulatory bodies have occurred with respect to the issuer or a wide array of related persons, including directors, executive officers, or 20% or greater shareholders or other affiliates. Collectively, we refer to the above as the “Issuer Covered Persons”.

In addition, an otherwise eligible issuer will be unable to rely on the Rule 506 exemption if in connection with the offering any remuneration will be paid to a broker-dealer or other person (a “Solicitor”) to solicit potential purchasers in the offering if a disqualifying event has occurred with respect to any Solicitor or certain related persons of the Solicitor. Collectively, we refer to the above as the “Solicitor Covered Persons”.

Under a grandfathering rule, if the disqualifying event occurred prior to September 23, 2013, the exemption will continue to be available, but only if the disqualifying event is disclosed to potential purchasers in writing a reasonable period of time prior to the time of sale.

The rule provides certain other exemptions, including an exemption if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. The SEC did not adopt a particular standard of “reasonable care”.

The new rules apply to any sale of securities under Rule 506 that is made on or after September 23, 2013, including any exercise of outstanding warrants or other convertible securities that are exercised on or after September 23, 2013 for cash in reliance upon Rule 506.

Recommendations for Issuers

Advance planning is key for issuers wanting to utilize Rule 506 in future offerings. Whether or not an issuer is currently contemplating a Rule 506 offering, we recommend that issuers:

• require that each director, officer, 20% shareholder and other affiliates complete a questionnaire on a recurring (at least annual) basis, confirming whether any disqualifying event has occurred and in that questionnaire agree to promptly inform the issuer of any change;
• confirm whether the issuer or any of its predecessors, subsidiaries or sister companies has had any disqualifying event occur;
• require potential officers and directors complete a questionnaire prior to their appointment to determine whether the person is subject to a disqualifying event;
• if prior verification is not possible, verify, promptly after the person becomes an Issuer Covered Person, whether the person is subject to a disqualifying event;
• obtain written confirmations from any Solicitor that will directly or indirectly receive any remuneration for solicitation of potential purchasers a Rule 506 offering, that the Solicitor Covered Persons are not subject to a disqualifying event, and are not aware of any other person that will directly or indirectly receive any such remuneration;¹ and
• if a disqualifying event has occurred, but the grandfathering provision is available because the event occurred prior to September 23, 2013, disclose such disqualifying event in the written offering materials or subscription agreement for any Rule 506 offering.

If a disqualifying event occurs on or after September 23, 2013 with respect to a person with whom the issuer has a relationship that may be severed, such as a director, officer or broker-dealer selling agent, the issuer could potentially sever the relationship, or change the nature of the relationship, in order to ensure that Rule 506 remains available.

Recommendations for Broker-Dealers

We recommend that broker-dealers and other Solicitors that directly or indirectly receive remuneration for solicitation of potential purchasers in Rule 506 offerings:

• confirm whether the Solicitor has experienced any disqualifying event;
• require that each of the other Solicitor Covered Persons complete a questionnaire on a recurring (at least annual) basis, confirming whether any disqualifying event has occurred and in that questionnaire agree to promptly inform the Solicitor of any change;
• verify, prior to the time any new person becomes a Solicitor Covered Person, whether the person is subject to a disqualifying event;
• develop information packages that can assist issuers in demonstrating that they exercised “reasonable care” in confirming that none of the Solicitor Covered Persons has experienced any disqualifying event;
• obtain written confirmations from any issuer on whose behalf the Solicitor will conduct a Rule 506 offering that the Issuer Covered Persons are not subject to a disqualifying event, and develop due diligence procedures for establishing that the issuer exercised “reasonable care” in confirming the same; and
• if a disqualifying event has occurred, but the grandfathering provision is available because the event occurred prior to September 23, 2013, disclose such disqualifying event in the written offering materials or subscription agreement for any Rule 506 offering.

If a disqualifying event has occurred with respect to a Solicitor Covered Person with whom the Solicitor has a relationship that may be severed, such as a director or officer, the Solicitor could potentially sever the relationship, or change the nature of the relationship, in order to ensure that Rule 506 remains available or to avoid the necessity of disclosure.

^{1  An issuer seeking to establish “reasonable care”, such that the exemption will remain available if a disqualifying event was not discovered, may be required to take additional steps. In the adopting release for the new rules, the SEC suggested that a representation from a Solicitor regarding the Solicitor Covered Persons may be inadequate, and that to establish “reasonable care” the issuer may be required to either make direct inquiry of all Solicitor Covered Persons, or combine a Solicitor questionnaire with searches of publicly available databases such as FINRA’s BrokerCheck system.}