The IPO Plot Thickens: The SEC Gets Though on "Bad Actors"
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The IPO Plot Thickens: The SEC Gets Though on "Bad Actors"

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Under a new Rule 506(d), a company considering an IPO cannot rely on exemptions if certain “covered persons” had a “disqualifying event” after the effective date of the amendments. If such an event......

Under a new Rule 506(d), a company considering an IPO cannot rely on exemptions if certain “covered persons” had a “disqualifying event” after the effective date of the amendments. If such an event occurred prior to
September 23, 2013, it would not lead to disqualification but would have to be disclosed with “reasonable prominence”2 to investors.

Covered persons include directors and certain officers, general partners and managing members of the issuer, as well as individuals compensated for soliciting investors and general partners, directors, officers and managing members of any compensated solicitor involved—collectively, a significant cast of actors.

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  • 1. The IPO Plot Thickens: The SEC Gets Tough on “Bad Actors” A LexisNexis® White Paper
  • 2. Highlights New Headaches • Dodd-Frank required the SEC to adopt rules to prohibit use of Rule 506 exemptions under Regulation D for any securities offerings in which certain felons and other “bad actors” are involved. • Companies will need to conduct documented factual inquiries aimed at gathering an in-depth knowledge of executive officers and others to determine whether any ineligible individuals may be involved in an offering. Here’s what has happened to alter the playbook for many companies on the verge of going public. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) required the SEC to adopt rules to prohibit use of Rule 506 exemptions under Regulation D for any securities offerings in which certain felons and other “bad actors” are involved. • New Rule 506(c) stemming from the JOBS Act relates to a special class of offerings in which the use of general solicitation and advertising is allowed, provided certain conditions are met. • Lawyers could find themselves answering a variety of interpretational questions, while also addressing other worries related to compliance with the new rules. • Companies should also be prepared for greater regulatory scrutiny under the provisions. Introduction Hollywood, as a metaphor for movies and television in America, is all about illusion and the suspension of disbelief. Real life, on the other hand, is generally unscripted and less dramatic. Individuals are understood to be more nuanced and, well, genuine, compared with those we see depicted on the big screen. For one thing, they have real-life foibles. The problem with that latter point, if you’re with a company that’s about to launch an initial public offering (IPO) under new rules issued by the Securities and Exchange Commission (SEC), is that some of those “foibles” among your main characters could lead to serious complications. Indeed, the provisions could potentially lead to some embarrassing revelations concerning individuals who, as a consequence of certain conditions, might be effectively barred from significant capital market involvement. The IPO Plot Thickens: The SEC Gets Tough on “Bad Actors” The rules were to be “substantially similar” to disqualification provisions of Regulation A, which also applies to small initial public offerings. As a result, amendments to Regulation D came into effect1 on September 23, 2013, and because they focus on the most frequently used private placement exemptions from SEC registration—along with some important new provisions—they are expected to cause added due diligence headaches for securities market participants. Covered Persons and Disqualifying Events Under a new Rule 506(d), a company considering an IPO cannot rely on exemptions if certain “covered persons” had a “disqualifying event” after the effective date of the amendments. If such an event occurred prior to September 23, 2013, it would not lead to disqualification but would have to be disclosed with “reasonable prominence”2 to investors. Covered persons include directors and certain officers, general partners and managing members of the issuer, as well as individuals compensated for soliciting investors and general partners, directors, officers and managing members of any compensated solicitor involved—collectively, a significant cast of actors. Disqualifying events are also comprehensive by definition. They include criminal convictions, court injunctions and restraining orders, certain SEC disciplinary, cease-and-desist and stop orders, and suspension or expulsion from membership in a self-regulatory organization. Moreover, issuers are required to exercise “reasonable care” in establishing that covered persons are not subject to the specified disqualifying events. That means companies will need to conduct documented factual inquiries
  • 3. aimed at gathering an in-depth knowledge of executive officers and others to determine whether any bad actors may be involved in an offering. The SEC has also indicated that for delayed or long-lived offerings, reasonable care includes updating the factual inquiry, which can include periodic rechecking of information by various means, “depending on the circumstances.” But Wait—There’s More In addition to the provisions mandated by Dodd-Frank, the SEC also amended Regulation D to insert a new rule required by the irresistibly named3 2012 Jumpstart Our Business Startups (JOBS) Act. Rule 506(c) created a special class of offerings in which the use of general solicitation and advertising in print, social media, websites, radio and other forms of public communications is allowed, provided certain conditions are met.4 It’s hoped that such a radical new approach will create an even bigger boom in investment activity for early-stage companies. Given that the existing Rule 506(b) exemption for private offerings prompted more than $1.3 trillion in funding in 2012 alone,5 even a small increase in investment could make 2014 a banner year for IPOs. Reasonable Care and Compliance Vigilance Even so, lawyers might well find themselves answering a variety of interpretational questions regarding the large number of potential covered persons involved in an offering, while also addressing other worries related to compliance. For example, a key element of the new SEC rules relies on a favorite weasel word in the legal profession: “reasonable,” as in companies must exercise “reasonable care” in vetting covered persons and take “reasonable steps” to ensure that they raise funding from accredited investors only in Rule 560(c) offerings. In the past, companies could rely simply on representations by principals and investors, whereas the new rules explicitly require heightened due diligence. The IPO Plot Thickens: The SEC Gets Tough on “Bad Actors” Additionally, for Rule 506(c) offerings, advertisements will need to be reviewed carefully to confirm that they are not misleading or do not fail to disclose material information. Telemarketing and email solicitations have other laws that govern their use, which requires further compliance vigilance. Another factor to consider is that a failure to strictly follow the terms of Rule 506(c) where general solicitation was used leaves no other path to asserting an exemption from the SEC’s registration requirements. It’s a high-stakes roll of the dice. For all that, companies should also be prepared for greater regulatory scrutiny under the new provisions. Worth the Price of Admission? Indeed, even before the rules were implemented, there was concern6 that the provisions could become “a boon to boiler-room operators, Ponzi schemers, bucket shops, and garden-variety fraudsters”—in other words, the very types of characters that Hollywood likes to celebrate in movies such as the Martin Scorsese-helmed The Wolf of Wall Street.7 The film, starring Leonardo DiCaprio (at his “debaucherous best,” according to one reviewer), is based on the real-life account of a stockbroker tied to a major securities fraud case in the 1990s.8 From the trailer alone, one can tell that the movie is a no-holds-barred depiction of everything that can—and shouldn’t—go wrong in the securities marketplace. It remains to be seen whether more such worst-case scenarios play out. In the meantime, the SEC likely won’t be much amused by Scorsese’s film. It appears to glorify the kind of fraudulent activity and excesses that regulators are working hard to eliminate, not least of all by getting tough on bad actors. Still, for those considering or preparing an IPO under the new rules, the movie might be worth the price of admission. That and a few extra dollars for popcorn should serve as a reminder that entertainment should not be confused with real life. In the latter, indulging in illusion and the suspension of disbelief can sometimes be serious liabilities.
  • 4. The Solution for Legal Professionals Through access to billions of SEC documents and records, late-breaking news and analysis of critical developments, and insight and guidance from leading securities practitioners, LexisNexis® Securities Solutions help litigators and transactional attorneys find and access the information they need to handle complex securities matters. To learn how you can stay at the top of your game in the rapidly changing environment of securities law, visit www.lexisnexis.com. For more topics that are transforming the legal industry, visit www.thisisreallaw.com. This document is for educational purposes only and does not guarantee the functionality or features of LexisNexis® products identified. LexisNexis does not warrant this document is complete or error-free. If written by a third party, the opinions may not represent the opinions of LexisNexis. 1 Alexander Davie, “SEC Implements the ‘Bad Actor’ Disqualification Provisions of Dodd-Frank,” Securities Law Blog, LexisNexis® Legal Newsroom, July 30, 2013, http://www.lexisnexis.com/legalnewsroom/securities/b/ securities/archive/2013/07/30/sec-implements-the-badactor-disqualification-provisions-of-dodd-frank.aspx. 2 U.S. Securities and Exchange Commission, “Disqualification of Felons and Other ‘Bad Actors’ from Rule 506 Offerings and Related Disclosure Requirements: A Small Entity Compliance Guide,” September 19, 2013, http://www.sec.gov/info/smallbus/ secg/bad-actor-small-entity-compliance-guide.htm. 3 Real Law Editorial Team, “Lifeline or Rising Tide? Understanding Emerging Growth Companies under the JOBS Act,” This Is Real Law (blog), April 10, 2013, http://www. thisisreallaw.com/hot-topics/2013/04/10/lifeline-or-rising-tide. html#sthash.QazAWQnk.6PA6idj7.dpuf. 6 U.S. Securities and Exchange Commission, “Public Statement by Commissioner: Investor Protection is Needed for True Capital Formation: Views on the JOBS Act,” March 16, 2012, http://www.sec.gov/News/PublicStmt/Detail/ PublicStmt/1365171490120#.UqXtRWRARD9. 4 Tanya Prive, “General Solicitation Ban Lifted Today – Three Things You Must Know About It,” Forbes, September 23, 2013, http://www.forbes.com/sites/tanyaprive/2013/09/23/generalsolicitation-ban-lifted-today-three-things-you-must-about-it/. 7 The Wolf of Wall Street, Official website, http://www.thewolfofwallstreet.com/. 8 Wikipedia contributors, “Jordan Belfort,” Wikipedia, The Free Encyclopedia, http://en.wikipedia.org/w/index.php?title=Jordan_ Belfort&oldid=585216809. 5 Cheryl Conner, “A Trillion Dollar Source of New Funding? The SEC’s New ‘Reg D’,” Forbes, July 13, 2013, http://www. forbes.com/sites/cherylsnappconner/2013/07/13/a-trillion-dollarsource-of-new-funding-the-secs-new-reg-d/. LexisNexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. Other products or services may be trademarks or registered trademarks of their respective companies. © 2014 LexisNexis. All rights reserved. BMH00416-0