Potholes in Compliance: Hidden Risks Under Rule 506(d)’s Bad Actor Disqualification

by Joshua Pirutinsky

I. Introduction

Sometimes the unexpected happens. But preparing for the unexpected is the essence of the compliance function. The failure to effectively prepare for risks unrelated to your core business can be disastrous.  A seemingly innocuous compliance breach could disqualify your firm from participating in a private offering of securities under Rule 506(d), known as the “Bad Actor” Disqualification.   Being a Bad Actor can have detrimental, if not fatal, consequences for your firm – hence the critical importance of making known certain unknowns.

Blue Sand Securities, a small private placement agent, nearly lost their core business due to a simple compliance breakdown which may have resulted in their being deemed a Bad Actor under Rule 506(d). The potential fatality of Blue Sand should alarm any compliance officer, as their demise would have been attributed to a minor and unrelated infraction rooted in a failure to adequately appreciate risks associated with their business. While compliance professionals are wise to allocate resources to issues that have a high likelihood of occurrence or sensitivity to their business line, they must also be wary of overlooking important but minor interstitials, such as the 506(d) Bad Actor Disqualification, that may bear outsized costs on their firm. There is much to learn from the example of Blue Sand Securities, and one should be sure to discover and prepare for the unknown before an employee puts their firm at risk.

A Cautionary Tale

Blue Sand Securities is a broker-dealer which acts as an agent and solicitor for private placement offerings.[1] As such, they are a “covered person” at risk of Rule 506(d)’s Bad Actor Disqualification.[2] Blue Sand derives the bulk of its revenue from continuous private placements under Rule 506 – compliance with SEC private placement requirements being a top priority of theirs. However, a managing member and executive officer failed to disclose their personal trading in several IPOs in violation of a FINRA requirement. This resulted in  Blue Sand becoming subject to the Bad Actor Disqualification.[3] IPOs are not, and have never been, a part of Blue Sand’s business model (the irony being that their specialty is private placements). Trading in IPOs does not per se violate any FINRA rule. The near-fatal transgression was the failure by an executive to independently disclose to FINRA that on nine separate occasions they traded in IPOs; that there was a clear failure by the compliance function to appreciate or communicate this risk to key personnel evinces a compliance failure of a high order.[4] The attenuated sequence in which the disqualification arose should not be seen as a frustration for the compliance function.[5] Instead, it should be a wake-up call that a failure to recognize and convey ancillary business risks can indirectly lead to the forfeiture of significant business, if not one’s entire core business practice.[6] Blue Sand was granted a waiver of disqualification. Not all firms will be so lucky.[7] While failure to be granted a waiver may have fatal consequences for your firm’s main business line,[8] the granting of a waiver can be exceedingly cumbersome, as many waivers are conditional on adherence to extensive compliance stipulations and other order requirements.[9] To avoid Blue Sand’s predicament, the compliance function must adequately address the hidden perils of Rule 506(d)’s Bad Actor Disqualification, as well as other uncommon but costly compliance risks.

The Bad Actor Disqualification

Rule 506(d) of the Securities Act deems certain “covered persons” who’ve experienced “triggering events” as “Bad Actors.”[10] Bad Actors may not use the Rule 506 private placement exemption from the public-registration requirement under § 5. Should a Bad Actor participate  in a private placement offering, they could disqualify all participants in the offering from Rule 506’s exemption, possibly leading to an unregistered public offering under § 5 and exposing the issuer to § 12(a)(1) ‘crush-out’ liability, as well as corollary sanctions.[11] Aside from the direct costs associated with such liability, Bad Actor status also bears heavy indirect costs, at times far heavier than the direct costs.[12] While the SEC allows for waivers if there is a showing of good cause and the Commission “determines that it is not necessary under the circumstances that an exemption be denied,”[13] a waiver resembles less a get-out-of-jail-free card than a ball and chain, with conditions nearly as costly as being a Bad Actor.[14] One can also receive a waiver if the administrator of the disqualifying order stipulates in the order that disqualification should not apply.[15] However, this would come at the significant cost of leverage in the face of settlement. The obvious solution to this compliance risk: taking preventive care to precipitate this potential pothole.

Preventive Care

The best practice in avoiding being a Bad Actor is to take prophylactic measures to avoid having to apply for a waiver. For all firms that derive business from Rule 506 private placement offerings,[16] as well as other securities issuers and advisers, counsel should provide a quarterly “Bad Actor” risk assessment. This would require counsel to both reiterate and emphasize what the “Bad Actor” risks are, how they manifest, who it implicates, and how to go about preventing infractions through the escalation of potential issues. Counsel could also have relevant actors disclose potential risks and engage in interactive workshops so as to thoroughly appreciate the risks posed by the most oblique of infractions, such as failing to disclose trading in certain unrelated IPOs as in Blue Sand. It would be helpful for counsel to create a map of the connections that could possibly lead to the Bad Actor Disqualification. An additional focal point for counsel should be incoming employees. If certain incoming employees are Bad Actors this could have the same deleterious impact as the above case. In this instance, counsel must implement a Bad Actor portion in any background-check and include a Bad Actor disciplinary questionnaire prior to the onboarding of new employees who may serve in such capacity that would trigger disqualification for the firm. Such a questionnaire should be updated annually, and for firms actively using Rule 506, affirmed quarterly. Effective communication in these risk assessments is vital in maintaining the integrity of the compliance function, which should operate to both mitigate the effects and prevent the occurrence of transgressions which may be unrelated to the firm’s core business. While there is a cost to compliance, being a Bad Actor, or receiving a conditional waiver of Bad Actor status, is likely more costly for both you and your firm. The Counsel’s road is replete with potholes. Don’t let the costly Rule 506(d) be one of them. 

Footnotes

[1] In the Matter of Blue Sand Securities LLC Waiver of Disqualification under Rule 506(d)(2)(ii) of Regulation D (Jun. 30, 2017) (PDF: 3,462 KB)

[2] 17 C.F.R. § 230.506(d)(1) (2013).

[3] Under 506(d)(1)(iv), an offering is disqualified from availing the Rule 506 exemption from §5 requirements if a managing member of a solicitor in the offering is suspended from an “affiliated securities association,” such as FINRA.

[4] The manager claimed that they were entirely unaware of such trading, and that it was conducted by their brokers. It, though, seems worse that the manager didn’t appreciate the importance of remaining aware of their implication in their broker’s actions, or the attendant risk of running afoul of FINRA restrictions.

[5] The attenuation being the vague relationship between Blue Sand’s core business and the risk to it arising under unexpected and unrelated circumstances.

[6] Beyond the inability to operate their business for the duration of the FINRA suspension, Blue Sand was exposed to contract termination provisions should they have be deemed a Bad Actor. Blue Sand’s tenuous position as a solicitor in private placement offerings would likely have led to a significant drop-off in business had they been deemed a Bad Actor for even a short period of time.

[7] Although the SEC does not record information on denied waivers, it has been asserted that more waivers are rejected than accepted. Commissioner Luis A. Aguilar, Enhancing the Commission’s Waiver Process (Aug. 27, 2015).

[8] See In the Matter of Blue Sand Securities LLC Waiver of Disqualification under Rule 506(d)(2)(ii) of Regulation D (Jun. 30, 2017) (PDF: 3,462 KB); In the Matter of Piper Jaffray & Co. Waivers of Disqualification under Rule 506(d)(2)(ii) of Regulation D and Rule 262(b )(2) of Regulation A (July 20, 2015) (PDF: 973 KB); In the Matter of Aegis Capital Corp. Waiver of Disqualification under Rule 506(d)(2)(ii) of Regulation D (Sept. 14, 2015) (PDF: 548 KB). One may still incur immense cost in the face of a waiver denial if their core business is not related to private placement offerings. See In the Matter of Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corporation, Waiver of Disqualification under Rule 506(d)(2)(ii) of Regulation D Exchange Act, Release No. 34-75083 (June 1, 2015) (PDF: 1,492 KB).    

[9] Infra, n. 13.

[10] Supra, n. 2.

[11] Securities and Exchange Commission, Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings and Related Disclosure Requirements, A Small Entity Compliance Guide (Sept. 19th, 2013); 15 U.S.C. 77e; 15 U.S.C. 77l(a)(1). Violating § 5 for purposes of § 12(a)(1) is particularly unforgiving as the standard applied is strict liability.    

[12] The remedy under § 12(a)(1) is restitution, which results in disgorgement of any funds raised from the unregistered public offering. While this is severe, the additional cost of being barred from Rule 506 offerings can be terminal to a firm whose primary business is derived from these offerings. 

[13] 17 C.F.R. § 230.506(d)(2)(ii) (2013).

[14] Additional compliance costs associated with a waiver arise where either the waiver is conditional upon compliance with the disqualifying order, or the waiver grant is conditional on compliance with specific provisions within the waiver itself. For examples of cumbersome waiver conditions, see In the Matter of Bank of America, N.A. and Merrill Lynch, Inc., Order under Rule 506(d) of the Securities Act of 1933 Granting a Waiver of the Rule 506(d)(1)(ii) Disqualification Provision (Nov. 25, 2014) (PDF: 28 KB); In the Matter of National Asset Management, Inc. Waiver of Disqualification under Rule 506(d)(2)(ii) of Regulation D (Oct. 25, 2015) (PDF: 893 KB); In the Matter of Citigroup Global Markets Inc., Waiver of Disqualification under Rule 506(d)(2)(ii) of Regulation D (Jan. 26, 2017) (PDF: 5,483 KB). 

[15] 17 C.F.R. § 230.506(d)(2)(iii) (2013). See, e.g., In the Matter of HSBC Inc., Order Instituting Proceedings Pursuant To Section 6(c) and (d) of the Commodity Exchange Act, at 5 (Jan. 29, 2018) (PDF: 160 KB).

[16] Which is by far the most significant provision under which firms would raise funds from the private market. See VLADIMIR IVANOV & SCOTT BAUGUESS, SEC, CAPITAL RAISING IN THE U.S.: AN ANALYSIS OF UNREGISTERED OFFERINGS USING THE REGULATION D EXEMPTION 2009–2012, at 7 (2013), http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered -offerings-reg-d.pdf.

Joshua Pirutinsky is a J.D. Candidate at New York University School of Law, Class of 2019 and a Student Fellow with the Program on Corporate Compliance and Enforcement.

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