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The SEC’s Latest C&DIs Related to Bad Actor Disqualification and Beneficial Ownership

Last Friday the Division of Corporation Finance released another set of Compliance and Disclosure Interpretations (C&DIs), mostly related to subsection (d) of the private offering exemption afforded by Regulation D, Rule 506 (bad actor disqualification) and the determination of beneficial ownership for purposes bad actor disqualification.

To briefly recap: Rule 506 contains a “bad actor” disqualification provision which provides, in relevant part, that the Rule is unavailable if an issuer of securities or any number of persons associated with that issuer (predecessors, directors, executive officers, etc.) including “any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power … ” is a bad actor, as defined in subsection (d) of the Rule.

The new C&DIs are summarized below (you’ll note that there are a lot of bullet points but really only five C&DIs related to Rule 506 were released):

When does a shareholder become a beneficial owner …

  • The bad actor disqualification determination must be made at the time of each sale of securities. Rule 506(d) provides that no exemption will be available for a sale if any covered person is subject to a bad actor triggering event at that time. A shareholder that becomes a 20% beneficial owner upon completion of a sale of securities is not a 20% beneficial owner at the time of the sale; however, such shareholder would be a covered person with respect to any sales of securities that are made while it was a 20% beneficial owner. [260.28]

How to determine beneficial ownership for Rule 506(d) …

  • The term “beneficial owner” in Rule 506(d) is interpreted in the same way as under Exchange Act Rule 13d-3, to mean any person who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares, or is deemed to have or share: (1) voting power, which includes the power to vote, or to direct the voting of, a security; and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, a security. [260.29]
  • Beneficial ownership includes both direct and indirect interests, determined in the same way that beneficial ownership is determined under Exchange Act Rule 13d-3, as such it is necessary to look through entities to determine beneficial ownership. [260.30]
  • Beneficial ownership of group members and groups should be analyzed in the same way as under Exchange Act Rule 13d-3 and 13d-5(b): [260.31]
    • Shareholders that enter into a voting agreement under which each shareholder agrees to vote its shares of voting equity securities in favor of director candidates designated by one or more of the other parties to the voting agreement have formed a group, and the group beneficially owns the shares beneficially owned by its members. [260.31]
    • Parties to the voting agreement that have or share the power to vote or direct the vote of shares beneficially owned by other parties to the agreement (e.g., through receipt of an irrevocable proxy or the right to designate director nominees for whom the other parties have agreed to vote) will beneficially own such shares. [260.31]
    • Parties to the voting agreement that do not have or share the power to vote or direct the vote of other parties’ shares would not beneficially own such shares solely as a result of entering into the voting agreement. [260.31]
    • If a group is a 20% beneficial owner, then bad actor disqualification or disclosure obligations would arise from court orders, injunctions, regulatory orders or other triggering events against the group itself. [260.31]
    • If a party to the voting agreement becomes a 20% beneficial owner because shares of other parties are added to its beneficial ownership, bad actor disqualification or disclosure obligations would arise from triggering events against that party. [260.31]

More on bad actor disclosure obligations …

(Bad actor disclosure obligations were also addressed in CorpFin’s last set of C&DIs.)

  • An order issued by a court or regulator, in accordance with Rule 506(d)(2)(iii), does not waive the bad actor disclosure requirements of Rule 506(e). [260.32]
  • Rule 506(e) pertains to an issuer’s obligation to provide disclosure of disqualifying events that would have triggered bad actor disqualification, except that these events occurred before September 23, 2013. [260.32]
  • Rule 506(d)(2)(iii) permits issuers to rely on the self-executing statement of a regulatory authority to avoid Rule 506 disqualification when that regulatory authority advises the Commission in writing or in its order, decree or judgment, that Rule 506 bad actor disqualification should not arise as a consequence of a disqualifying event that occurred on or after September 23, 2013. [260.32]
  • A regulatory authority such as a state securities commission may, however, determine that an order entered before September 23, 2013 would not have triggered bad actor disqualification because the violation was not a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale. (emphasis mine) [260.32]

Finally, CorpFin also released one C&DI related to the determination of beneficial ownership under Exchange Act Sections 13(d) and 13(g) and the reporting requirements of Regulation 13D-G (it pretty much mirrors the guidance of C&DI 260.31, but addresses the determination of beneficial ownership as it relates to shareholders of Exchange Act reporting issuers):

  • The formation of a group under Rule 13d-5(b), without more, does not result in the attribution of beneficial ownership to each group member of the securities beneficially owned by other members. [105.06]
  • Under Section 13(d)(3) of the Exchange Act, a group is treated as a new “person” for purposes of Section 13(d)(1), and a group is deemed to have acquired, by operation of Rule 13d-5(b), beneficial ownership of the shares beneficially owned by its members. (CorpFin notes that the analysis is different for Section 16 purposes. See Section II.B.3 of Exchange Act Release No. 28869) [105.06]
  • In order for one party to a voting agreement to be treated as having or sharing beneficial ownership of securities held by any other party to a voting agreement, evidence beyond formation of the group under Rule 13d-5(b) would need to exist. [105.06]
    • For example, if a party to a voting agreement has the right to designate one or more director nominees for whom the other parties have agreed to vote, the party with that designation right becomes a beneficial owner of the securities beneficially owned by the other parties, because the agreement gives that person the power to direct the voting of the other parties’ securities. [105.06]
    • Similarly, if a voting agreement confers the power to vote securities pursuant to a bona fide irrevocable proxy, the person to whom voting power has been granted becomes a beneficial owner of the securities under Rule Rule 13d-3. [105.06]
    • Conversely, parties that do not have or share the power to vote or direct the vote of other parties’ shares would not beneficially own such shares solely as a result of entering into a voting agreement. Note, however, that a contract, arrangement, understanding or relationship concerning voting or investment power among parties to the agreement, other than the voting agreement itself, may result in a party to the voting agreement having or sharing beneficial ownership of securities held by other parties to the voting agreement under Rule 13d-3. [105.06]
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