Is the SEC capable of blushing? Increasingly, there are occasions in which the Securities and Exchange Commission takes positions so inconsistent with the protection of investors and its own history and so deferential to the industry that one has to ask: What were they thinking? How can a federal agency be that tone deaf? This column will, first, examine the SEC's new policy toward when "bad actors" can use the vastly expanded Rule 506 and, second, focus on how these rules will likely be gamed.
In Release No. 33-9414 (July 10, 2013),1 the Commission has adopted rules to disqualify "felons and other 'bad actors' from Regulation D offerings."2 These rules were mandated by §926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which also instructed the SEC that its disqualification rules for Rule 506 offerings were to be "substantially similar" to the existing "bad actor" disqualification rules long contained in Rule 262 of Regulation A. However, §926 also expanded the list of disqualifying events. The new disqualification rules, which are set forth in a new Rule 506(d), are important for several reasons: First, almost all Regulation D offerings are done under Rule 506.3 Second, the use of Rule 506 is about to increase exponentially, as the JOBS Act has mandated that the SEC permit general solicitation and general advertising in connection with a private placement made pursuant to Rule 506 (at least if all purchasers are "accredited investors").4 Third, the disqualification rules will likely affect future settlement negotiations in SEC enforcement cases.
Although they were adopted in separate releases issued on the same day, new Rules 506(c) and (d) go hand in hand: The first greatly liberalizes how Rule 506 private placements can be conducted and the second bars felons and certain other "bad actors" from using Rule 506 for specified periods.
Many would think that this combination makes good sense. If private placements can now be advertised to the world by every form of media (and without prior review by the SEC), it seems easily understandable that persons convicted of securities fraud and related offenses or similar fraud-based civil violations should not be entitled to use this newly expanded and still untested exemption. In truth, newly revised Rule 506 largely expands and generalizes old Regulation A (which long permitted public solicitation in much smaller offerings), but Regulation A had become obsolete because of its low ceiling. The "bad actor" disqualification originated in the context of Regulation A.
Surprisingly, in its final rule, the SEC has effectively nullified the "bad actor" disqualifications for the present by providing that only "triggering events occurring after the effectiveness of the rule amendments" will be considered. In effect, all existing felons and fraudsters are grandfathered. Specifically, Rule 506(d)(1) says that an issuer cannot use Rule 506 if it or any executive officer, director, or certain other persons have "been convicted, within ten years before such sale" of certain securities fraud offenses. But it then provides in Rule 506(d)(2) that these disqualifications "shall not apply with respect to any conviction, order, judgment, decree, suspension, expulsion or ban that occurred or was issued before" 60 days after publication of the amended rule in the Federal Register.
Think what this actually means. A person convicted today of securities fraud could make a Rule 506 offering involving a general solicitation when that rule becomes effective later this month. Put more bluntly, Bernie Madoff could use the rule (at least unless he had been otherwise enjoined). To be sure, appropriate disclosure of the past history would have to be made.5 But if the regulatory violation involved only a civil consent decree or an order by a state securities regulator, the issuer's counsel could find ways to disclose this in boilerplate prose so that it did not sound very disturbing. In §926, Congress seems to have intended a prophylactic rule with a simple logic: "Commit a serious securities law violation and you lose the ability to avail yourself of Rule 506." But the SEC has now largely undercut that purpose (although those who commit triggering offenses after the rule's effective date in October or later will be denied access to Rule 506).
Given how frequently that the SEC has been accused of only enforcing the federal securities laws in a half-hearted, equivocal fashion, one would think that the Commission would have been more sensitive to the appearance this creates that it is favoring fraudsters over investors. In fact, the SEC is here acting, not simply as a weak-kneed enforcer, but rather as a generous Board of Pardons, granting immunity to those few persons that it has enjoined or held otherwise accountable within the last decade. If one were seeking to further tarnish an already compromised agency's reputation and image, this would be the way to do it.
So why did the SEC make this change, which was not in its original rule proposal? Commentators on the proposed rule had divided, with five suggesting that prior "bad actor" disqualifying events should be covered on investor protection grounds, and 15 objecting that to do so would be unfair and unforeseen. But this 3-to-1 majority in favor of grandfathering prior "bad actor" events proves only that law firms write more comment letters than do investors or public interest groups. Worse yet, counting the comment letters only incentivizes the industry to solicit more comment letters.
The only substantive argument noted in Release 33-9414 was that the Supreme Court's decision in Landgraf v. USI Film Products6 adopted a presumption against the retroactive application of a law and this might bar reaching prior triggering events. Still, Release 33-9414 notes that its decision to grandfather prior "bad actors" was based on "the views expressed by commenters, including concerns about potential unfairness."7 If we take the SEC at its word, this statement reflects the view that the interests of fraudsters outweigh those of investors.
Still, it is worth considering whether the Landgraf decision does compel the SEC to ignore prior "bad actor" events before the effective date of the new rule. In Landgraf, the plaintiff was sexually harassed by another employee and subsequently resigned her job and brought suit against her former employer for damages. The trial court found that the harassment had occurred, but was not sufficiently severe to justify her resignation. From this starting point, it followed logically that she was not entitled to equitable relief because her employment was not terminated in violation of Title VII. At the time of her claim, Title VII only authorized equitable relief, and thus her action for damages was also dismissed. But, while her appeal was pending, Congress enacted the Civil Rights Act of 1991, which authorized the recovery of compensatory and punitive damages. Granting certiorari to determine if the Civil Rights Act of 1991 applied retroactively, the court fashioned a two-part test for assessing retroactivity. First, a court looks at the statutory language to discern any clear Congressional intent. Second, if no express direction is provided in the legislation, a court must look to determine if the statute will have a genuine retroactive effect. Such a genuine retroactive effect is clearest, the majority said, where the new provision affects "contractual or property rights."8 Statutes that confer or oust jurisdiction, change procedures, or confer additional prospective relief are generally not subject to the presumption against retroactivity, whereas that presumption does apply to statutes "affecting substantive rights, liabilities or duties."9 Applying this test, the Landgraf majority found that punitive damages could clearly not be awarded based on conduct predating the statute, but that compensatory damages presented a closer question. After some agonizing, the court decided that because compensatory damages were essentially "backward looking," they were also barred because their "provision would attach an important new legal burden to that conduct."10 Most commentators have read Landgraf as establishing a vested rights standard: That is, if one would be deprived of a vested right or subjected to a new monetary liability, the statute should not be applied retroactively.
The few cases that have considered the retroactive application of the Dodd-Frank Act have divided, but they have concerned very different issues, such as whether its prohibition of pre-dispute arbitration agreements with respect to alleged retaliation against whistleblowers applies retroactively.11
All this leads to the bottom line question: Could Rule 506, with its bar of bad actors, have been applied retroactively to consider triggering events before the date of the rule? The better answer is that it could be for at least three reasons:
First, there is no vested right involved and no new liability has been created. No one has a statutory right to make a private placement through a general solicitation or general advertising. Indeed, at the time the Dodd-Frank Act was passed, no one could use a general solicitation to effect a private placement (only the later JOBS Act permitted that).
Second, the status quo has not truly been changed. Prior to the JOBS Act, the only way one could conduct a nationwide general solicitation of investors without registration was pursuant to Regulation A and that had long been subject to "bad actor" disqualifications (which Dodd-Frank used as its express model in its §926).12 Thus, persons settling enforcement cases with regulators were long aware that there would be collateral consequences from such a settlement; the Dodd-Frank Act only extended those consequences marginally. In this light, no "important new legal burden" has been added to the status of being a "bad actor." Although the definition of "bad actor" has been slightly extended in some areas by the Dodd-Frank Act, new Rule 506(d) covers considerably fewer persons than does Rule 262 under Regulation A.13
Third, Rule 506 fundamentally addresses prospective conduct: future offerings to the public, without SEC registration or oversight. The purposes of the federal securities laws is to protect the public, particularly from fraud, and disallowing past fraudsters from using a very broad exemption seems a sound safeguard.
The bad actor who would be disqualified by Rule 506(d) also has a number of alternatives. First, he can apply to either the SEC, the court, or the other regulator that imposed the sanction for a waiver, and Rule 506(d)(2) says such a waiver can be granted "upon a showing of good cause." Thus, the penalty is not automatic. Second, an issuer barred from use of Rule 506 (which is a safe harbor rule) can still make a private placement under the "common law" standards of the preexisting case law. Or, it can use an alternative exemption; or, it can sell its securities extraterritorially (possibly under Regulation S). Thus, while issuers might prefer to use Rule 506, they still have many other options (including even registration). For all these reasons, they are not subjected to any serious penalty.
Finally, even if the Landgraf argument is thought colorable, the relevant date for determining retroactivity should have been the date of passage of the Dodd-Frank Act in 2010, not Rule 506's effective date this month.
By analogy, suppose a state passed legislation broadly precluding past sex offenders from employment as school teachers for 10 years after the time of their misconduct, but also added a waiver provision under which this disbarment provision could be waived "for good cause shown." There seems little doubt that such a provision would be upheld.
Let's now turn to how new Rule 506(d) will affect the actual practice of securities law. The new Rule has some special provisions that will clearly affect the settlement of SEC enforcement actions. For example, under Rule 506(d)(1)(v), it will be a "bad actor" disqualifying event if a person is:
subject to any order of the Commission entered five years before such sale that, at the time of such sale, orders such person to cease and desist from committing or causing a violation or future violation of: (A) any scienter-based anti-fraud provision of the federal securities laws, including without limitation §17(a)(1) of the Securities Act of 1933…
Silently, this language deliberately excludes settlements based on §17(a)(2) and (a)(3) of the Securities Act, which sections do not require proof of scienter.14 As a result, in negotiating settlements of "cease and desist" proceedings, defense counsel will push hard to settle on such a non-scienter basis and thereby avoid a bad actor disqualification.
Similarly, the typical SEC consent decree enjoins the subject from violating the federal securities laws. But the definition of a disqualifying event specified in new Rule 506(d)(1)(ii) requires more: namely, that:
any order, judgment or decree entered within five years before such sale…restrain or enjoin such person from engaging or continuing to engage in any conduct or practice: (A) In connection with the purchase or sale of any security; (B) Involving the making of any false filing with the Commission; or (C) Arising out of the conduct of the business of an underwriter, dealer…investment advisor….
Thus, if the consent decree merely enjoins the defendant from violating the federal securities laws and does not go on further to specify the additional language in (A), (B), or (C), the injunction would not appear to amount to a disqualifying event. It is too early to predict whether the SEC's staff will permit this loophole to be exploited, but given the demonstrated willingness of some SEC enforcement staffers to settle on any basis, the possibility is there.
Finally, because suspension or expulsion from membership in an exchange or registered national securities association is now a "bad actor" disqualifying event, counsel may advise their clients instead to resign if they can thereby avoid expulsion.
When the issuer is not itself named as a defendant, but a covered employee or director is, the practical answer may be the individual's resignation or dismissal. Rule 506(d) probably will provoke some employee terminations to avoid the issuer's disqualification. This could produce some real conflicts between counsel for the individual defendants and counsel for the corporate issuer, as neither will want to bear the collateral consequences of the alleged misconduct. Conceivably, employees could resign as officers, but be rehired as consultants or independent contractors. This would satisfy the technical requirements, provided that the former employee is not paid, directly or indirectly, for the "solicitation of purchasers."
In the last analysis, the broad and vast pardon granted by Rule 506(d) will not greatly impact the securities markets, but it is sadly symptomatic of the failures of the current SEC. When push comes to shove, it is favoring the industry—and the most dubious members of the industry at that—over investors. Ten years ago, that would have been unthinkable at the SEC.
John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.
1. See Release No. 33-9414 ("Disqualifications of Felons and Other 'Bad Actors" From Rule 506 Offerings"), 2013 SEC LEXIS 2000, 2013 WL 3817311 (July 10, 2013).
2. This language is taken from the caption of Release No. 33-9414. The term "bad actors" has long been used in connection with Regulation A and Rule 505.
3. An estimated 90 to 95 percent of all Regulation D offerings are done pursuant to Rule 506. See Release No. 33-9414, supra note 1, at *5 n.15 (citing statistics). This is probably because no disclosure document is mandated by Rule 506 for sales to accredited investors.
4. This requirement was set forth in §201 of the JOBS Act and is now codified at §4(b) of the Securities Act of 1933.
5. Rule 506(e) ("Disclosure of prior 'bad actor' events") mandates that the issuer furnish to each purchaser "a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification but occurred before" the rule's effective date. Under Rule 506(e), failure to supply such information does not prevent reliance on the rule if the issuer can establish that "in the exercise of reasonable care" it "could not have known of the undisclosed matter or matters."
6. 511 U.S. 244 (1994).
7. See Release No. 33-9414, supra note 1, at *129 to *130.
8. 511 U.S. at 271.
9. Id. at 279.
10. Id. at 283.
11. Compare Pezza v. Investors Capital, 767 F. Supp. 2d 225 (D. Mass. 2011) and Wong v. CKX, 890 F. Supp. 2d 411 (S.D.N.Y. 2012) (both permitting retroactive application), with Henderson v. Masco Framing, 2011 U.S. Dist. LEXIS 80494 (D. Nev., July 22, 2011) (and Weller v. HSBC Mortg. Servs., 2013 U.S. Dist. LEXIS 130544 (D. Colo. Sept. 11, 2013) (both rejecting retroactive application).
12. Rule 262 of Regulation A, 17 C.F.R. §230.262, basically provides the template for Rule 506(d), except as noted in the next footnote. Section 926 of the Dodd-Frank Act mandated that the Rule 506(d) specify restrictions "substantially similar" to those in Regulation A, which necessarily meant those in Rule 262.
13. For example, Rule 262 covers any "officer" of the issuer (see Rule 262(b)), whereas Rule 506(d) covers only "executive officers" or "other officers participating in the offering" (see Rule 506(d)). Rule 262 covers any "beneficial owner of 10 percent or more of any class of…[the issuer's] equity securities," while Rule 506(d) moves this level up to 20 percent.
14. See Aaron v. S.E.C., 446 U.S. 680 (1980) (finding that §§17(a)(2) and 17(a)(3) do not require the SEC to prove scienter, while §17(a)(1) does).