May 17, 2010

Dodd Bill Amendments: A (Partial) Reprieve for Regulation D

A while back, I blogged how Regulation D would get hammered under Section 926 (and Section 412) of the Dodd bill. Joe Wallin of Davis Wright Tremaine reports that Senators Bond, Warner, Brown and Cantwell have proposed an amendment (#4037) to the Dodd bill that would:

– Remove the ridiculous and industry killing 120-day wait period
– Remove the “go back in time” provision, which would have re-adjusted the accredited investor financial thresholds in a way that would have wiped out 2/3rds of existing angel investors qualifying as “accredited investors”
– Exclude the value of an investor’s primary residence in determining whether the investor would meet the net worth standard
– Add a “bad boy” provision to Rule 506 offerings

Even though some groups are excited – like the Angel Capital Association – some still see issues with the amendment. For example, Alan Parness of Cadwalader has these thoughts:

1. Regarding the proposed rewrite of Section 412, I don’t have any particular problem, noting that the current $1 million minimum net worth standard in the SEC’s Rule 501(a)(5) would be in place for 4 years from enactment of the bill.

Obviously, the main question is how many persons would be eliminated as accredited investors under Rule 501(a)(5) if the value of the investor’s primary residence were removed from the net worth calculation (those of you handling public offerings of direct participation programs subject to state filings should be familiar with NASAA’s Guidelines, whereby investor suitability standards include a minimum net worth requirement which excludes the value of the investor’s home, home furnishings and automobiles – see, e.g., Sec. II.B of NASAA’s Omnibus Guidelines at NASAA Reports par. 2322).

2. Regarding Section 926, I’m troubled by the following:

– The preamble to paragraph (2) provides for disqualification of “any offering or sale of securities by a person.” What person or persons will be covered by this provision? It’s not clear whether it would encompass the same people subject to disqualification by the SEC’s Rule 262.

– Paragraph (2)(A) includes only final orders of state securities and insurance regulators, and federal and state banking regulators, as opposed to court orders, and contains no limit as to when the “final order” may have been entered (compare Rule 262, which in most cases imposes a 5-year “look-back” limit). One possible issue would be whether an order is “final” if it’s been issued by the regulator, but is in the process of being challenged by the respondent through administrative or judicial proceedings.

– Paragraph (2)(A)(ii) covers violations of “any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct.” Obviously, the question is what particular conduct is deemed to be “fraudulent, manipulative, or deceptive” under a particular state’s law or regulations. For example, NY Gen. Bus. Law Secs. 352(1) and 352-i provide that any violation of a number of provisions in GBL Article 23-A (NY’s infamous “Martin Act”), constitutes a “fraudulent practice,” including the requirement in Section 359-e(8) that a dealer file a “further state notice” with the NY Department of State for certain offerings (for those of you not familiar with this form, it’s a pointless piece of paper which only serves as a revenue source, and it’s been preempted by ’34 Act Section 15(h)(1) as regards SEC-registered broker-dealers).

Query whether there are provisions under other states’ securities or insurance laws, or federal or state banking laws, or rules thereunder, which deem a violation of a filing, recordkeeping or some other innocuous requirement to be “fraudulent, manipulative, or deceptive.” Further, this provision is an open invitation for states to amend their securities, banking and/or insurance laws or regulations to designate a broad range of violations as “fraudulent, manipulative, or deceptive,” and thereby trigger a disqualification.

– Paragraph (2)(B) contains no time limit on when the particular conviction occurred. Compare the SEC’s Rule 262(a)(3), imposing a 5-year look-back, and Rule 262(b)(1), imposing a 10-year look-back, on the convictions specified in those provisions.

– Unlike the preamble to Rule 262, whereby the SEC may waive any disqualification “upon a showing of good cause,” there is no mechanism provided for waiver of any disqualification under par. (2), whether by the SEC or by the particular state regulator (for reasons of uniformity, I believe granting the SEC authority to grant waivers to be the better approach).

– If, like the SEC’s Rule 262(b), the proposed disqualification from use of Rule 506 may be triggered by reason of a beneficial owner of 10% or more of the issuer’s equity securities being a “bad boy,” that raises a number of practical problems as to how an issuer can be absolutely certain that none of its 10%+ beneficial owners is a “bad boy.”

First, how is “beneficial owner” to be defined for purposes of the disqualification? In similar fashion to SEC Exchange Act Rule 13d-3 or 16a-1(a), or in a different manner? There are many possible variables in that regard. Also, if “beneficial owner” is to include someone owning 10% or more of an issuer’s equity securities indirectly through another person, say, for example, that 20% of the interests in an issuer commencing a Rule 506 offering are owned by an offshore entity. Can the issuer in that case simply rely in good faith on a representation by that entity that no person holding 50% or more of its equity interests is a bad boy? What if that representation proves to be false? Does the issuer pay the price in that case with a loss of the Rule 506 exemption?

Also, one basic issue – does Congress really expect that adding a “bad boy” disqualification will deter the real securities crooks out there? In reality, I believe it will only make the process more cumbersome and expensive for honest issuers who seek to comply with the law by doing their homework and obtaining appropriate certifications (hopefully truthful!) those from the persons covered by the rule, while issuers with “bad boys” running the show will simply proceed along their merry way, either ignoring federal and state securities laws altogether, or claiming reliance on other exemptions without a bad boy disqualifier.

I wonder how many instances can be cited where a state uncovered a “bad boy” lurking behind an issuer for which a Form D was filed, and such person’s involvement or nefarious background was not disclosed to investors (or, worse, such person committed a fraud in the course of the offering), as opposed to cases where a state uncovered a “bad boy” behind an issuer effecting a fraudulent offering which failed to make any filing with the SEC or the state?

3. On the practical side, I also fear that the potential for disqualification under Section 926 could lead to strong-arm tactics by certain state regulators in the course of investigations, forcing respondents to settle for extraordinary remedies in lieu of an order which would disqualify them from future Rule 506 offerings.

Put into the context of issues that have arisen recently in connection with Rule 506 offerings, say a state securities administrator decides to pursue an entity serving as the general partner of various limited partnerships which effected Rule 506 offerings in the state, as well as the entity’s individual principals, on the basis that, despite the absence of any complaints from local investors or other evidence that the offerings might have been fraudulent: (i) notice filings were made later than required by law or rule, (ii) notice filings were not made as required by law or rule, and/or (iii) the issuers refused to submit copies of offering materials for such offerings upon the state’s request.

Facing the state’s threat to issue an order under a statute which deems a violation of any provision of the statute or a rule thereunder to be a “fraudulent practice,” which would disqualify the general partner and its principals from participating in future Rule 506 offerings pursuant to par. (2)(B) of Section 926, and, after concluding that the cost and time required to challenge such an order through the requisite administrative and judicial proceedings would be impractical (let alone the likelihood of success before the local administrative or judicial panels which would hear such a challenge), the respondents capitulate and agree to make a rescission offer to all investors in that state and pay a huge penalty to the state. Unrealistic? I don’t think so.

RiskMetrics’s ISS Reveals All: Full GRId Methodology Now Available

A few weeks ago, RiskMetrics released a fuller explanation – a 193-page technical paper – about how their new GRId governance rating framework will work, updating the outline they issued back in March (here’s ISS’s 8-page summary of GRId). We are posting memos analyzing this new information in our “Governance Ratings” Practice Area.

Last week, The Corporate Library weighed in on the long-standing debate about what governance ratings actually mean to investors, particularly those related to ESG issues (Environmental, Social and Governance).

Navigating Corp Fin’s Comment Process

Join us tomorrow for the webcast – “Navigating Corp Fin’s Comment Process” – to hear former SEC Senior Staffers Linda Griggs of Morgan Lewis & Bockius, John Huber of Latham & Watkins, Dave Lynn of and Morrison & Foerster and Bill Tolbert of Jenner & Block explain the process by which the SEC Staff issues comments as well as provide their practical guidance about how to respond.

We’ve posted some great course materials for this program, including:

– “40 Rules of the Road for Corp Fin’s Review Process” – John Huber and Joel Trotter, Latham & Watkins
– “SEC Comment Letter Trends in 2009” – Dave Lynn, Morrison & Foerster

– Broc Romanek