As we’ve described previously, new Rule 506(d) imposes a number of bad actor disqualifications on certain persons that are associated with the issuer, including officers, directors, and 20% beneficial owners. On January 3, 2014, the SEC released a new set of C&DIs relating to 20% beneficial owners. Here is what we learned from this latest round of FAQs:
Issuers will need to perform due diligence on any person that is going to become a 20% beneficial owner in an offering, because it will impact the remainder of the offering. For example, assume that there is an active Rule 506 offering pursuant to which the issuer is holding periodic closings. An existing 15% shareholder subscribes to purchase shares in the offering that, upon the initial closing, will make her a 20% beneficial owner. Although Rules 506(d) and 506(e) don’t apply to the shareholder for purposes of the transaction that makes her a 20% beneficial owner, they DO apply to each subsequent sale in the offering (i.e., each subsequent sale can be tainted by the bad acts of the now-20% owner). This scenario is not likely to be a common one, but it’s something that issuers should keep in mind nonetheless.
The term “beneficial owner” in Rule 506(d) will be interpreted the same way that the term is defined for purposes of Exchange Act Rule 13d-3. In other words, beneficial ownership consists of the direct or indirect possession, including shared possession, of voting power and/or investment power. The provisions of Rule 13d-3 relating to when a person will and will not be deemed to be the owner of a security for purposes of determining beneficial ownership therefore also apply in the context of Rule 506 (e.g., a person with a right to acquire securities exercisable within 60 days is deemed to be the beneficial owner of those securities). Likewise, both direct and indirect beneficial ownership are relevant for purposes of Rule 506, just as they are for purposes of Rule 13d-3, so it is necessary to look through entities – perhaps multiple layers of entities – in order to determine who the ultimate beneficial owners are.
Beneficial ownership of group members and groups will be analyzed under the same principles that apply under Exchange Act Rules 13d-3 and 13d-5(b). If shareholders enter into a voting agreement, they have thereby formed a group, and the group will be deemed to beneficially own all of the shares beneficially owned by each group member. If that aggregation exceeds 20%, then the group itself, as a distinct entity, is subject to Rule 506(d) and Rule 506(e). On the other hand, the individual group members will only be deemed to beneficially own those shares over which they have voting power. If a shareholder has ceded voting power over shares, those shares will not be attributed to her; if a shareholder has accepted voting power with respect to the shares of the other group members, those shares will be attributed to her, and could lead to her becoming subject to Rules 506(d) and 506(e).
C&DI 260.32 is a brain teaser that may have little practical application. Rule 506(d)(2)(iii) provides that a prohibited act or condition applicable to a covered person for purposes of Rule 506(d) will not affect the issuer “If, before the relevant sale, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing (whether contained in the relevant judgment, order or decree or separately to the Commission or its staff) that disqualification under paragraph (d)(1) of this section should not arise as a consequence of such order, judgment or decree.” However, even if an issuer has received one of these orders, if any conduct that initially gave rise to the order occurred prior to September 23, 2013, then the disclosure obligation in Rule 506(e) still applies (which requires disclosure of prior conduct that would have violated Rule 506(d) if the rule had been in effect at the time of the conduct). The post-September 23, 2013 order does not change the fact that conduct occurred prior to September 23, 2013 that would have constituted a violation of Rule 506(d) at that time if Rule 506(d) had then applied. The Commission further provides, though, that if there were a pre-September 23, 2013 order relating to conduct that could require disclosure under Rule 506(e), a post-September 23, 2013 regulatory authority could determine that the pre-September 23, 2013 order would not have constituted a violation of Rule 506(d), thereby eliminating the Rule 506(e) disclosure requirement with respect to the pre-September 23, 2013 order.
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