All Private Investment Funds Must Take Steps To Identify Bad Actors Under SEC Rules


On July 10, 2013, the Securities and Exchange Commission ("SEC") adopted amendments to Rule 506 of Regulation D under the Securities Act of 1933, as amended (the "Securities Act") which disqualify securities offerings (including offerings of interests/shares in U.S. and Non-U.S. hedge funds, private equity funds and venture capital funds in the U.S.) involving certain "felons and other 'bad actors'" from reliance on the Rule 506 offering exemption.

It is important to note that the new disqualification provisions apply to all Rule 506 offerings (i.e., both offerings involving general solicitation and advertising as permitted under the SEC's newly adopted Rule 506(c) and those involving no general solicitation or advertising as specified under the existing Rule 506(b) which will remain available).

Under the "bad actor" disqualification provisions, a private investment fund may not rely on the Rule 506 offering exemption if the fund or certain other persons (such as executive officers of the general partner and/or managing member of the fund, third party marketers and certain large fund investors) involved with the offering ("Covered Persons") has a disqualifying event (a "Disqualifying Event") after September 23, 2013 (the "Effective Date"), unless the disqualification is waived or otherwise remedied.

Any event occurring prior to the Effective Date that would be a Disqualifying Event had it occurred after the Effective Date will not disqualify a private investment fund from relying on Rule 506, but must be disclosed in writing to offerees a reasonable time prior to sale.   


Immediate Next Steps

Private investment funds seeking to rely on Rule 506 as of or following the Effective Date should take the following steps as soon as possible:

(i)      identify all potential Covered Persons;    


(ii)     determine whether any Covered Person has a Disqualifying Event (such as by distributing and obtaining questionnaires and certifications from each Covered Person regarding any Disqualifying Events);  


(iii)    review agreements and contracts with Covered Persons and, where necessary, obtain representations, covenants and/or certifications regarding whether such Covered Persons have had a Disqualifying Event;  


(iv)  amend subscription agreements to require applicable investors to provide information about potential Disqualifying Events relating to such persons;

(v)   amend any agreements or contracts with potential Covered Persons (e.g., placement agent agreements, employment agreements and agreements with investors) to include appropriate representations, disclosure requirements and other relevant provisions;

(vi)   implement compliance policies or procedures addressing the determination of whether a Covered Person has had a Disqualifying Event; and

(vii)   amend operating agreements to provide the authority for prompt mandatory redemption or withdrawal in the event a beneficial owner could subject the private investment fund to disqualification.  

Cheryl Spratt