Effective September 23, 2013, the Securities and Exchange Commission (the “Commission”) implemented Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which provided for, among other things, expanded liability for “bad actors” in connection with offerings made under Rule 506 of Regulation D of the Securities Act of 1933, as amended (a “Rule 506 Offering”). New Rules 506(d) and 506(e) now impose disqualification requirements on a wide-range of actors (known as “covered persons”) and events (known as “disqualifying events”).
Significantly, the new rules provide that a Rule 506 Offering is disqualified from the exemption from registration if the “issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order, or other disqualifying event that occurred on or after the effective date of the rule amendments.” The list of covered persons includes, among others, the issuer; directors, general partners, and managing members of the issuer; executive officers of the issuer; and beneficial owners of more than 20% of the issuer’s equity. Prior to the adoption of Rules 506(d) and 506(e), covered persons were typically subject to disqualification related to a failure to file a Form D.
This expanded application of the bad actor disqualification requirements to Rule 506 offerings presents a unique challenge to limited partnerships operating in the oil and gas industry. Oil and gas drilling programs may be structured in multiple tiers, oftentimes with a managing general partner, one or more investor general partners, and investor limited partners—both categories of general partners are ostensibly swept up by new Rule 506(d), whereas before they were not subject to such disqualification. These oil and gas programs are organized to provide an opportunity for both high and low risk investments. Investor general partners generally will be permitted to offset losses and deductions against income from any source, while limited partners generally will be allowed to offset losses and deductions only against passive income. Thus, both managing and investor general partners may claim a non-passive loss from the intangible drilling costs as long as the investor has general liability for partnership liabilities and obligations.
The question for these limited partnerships, accordingly, has become “Are investor general partners now covered persons under Rule 506(d)?” This unintended interplay between the securities laws and the tax code has left some oil and gas issuers wondering whether their multiple-tiered investing structures will remain viable in the future.
Issuers are currently struggling with whether investor general partners are true “general partners” in the covered persons sense because they play the role of an investor, but utilize the name of a manager. The SEC has noted that the list of covered persons under Rule 506(d) was written to “standardize the treatment of controlling persons of limited liability companies for disqualification purposes,” i.e., to provide a bright-line standard for issuers. But to complicate matters, the new rule was not written to focus on those “securityholders who do not control the activities of the issuer,” and the SEC stated that the rule was intended to “be applied based on whether securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right.” In all, the rule was meant to be both purposely straightforward by providing an exhaustive list of covered persons, while also capturing the SEC’s nuanced intent regarding “control.” Unfortunately, the SEC’s dual goals of clarity and purpose do not align with the tax code’s treatment of working interests in the oil and gas industry.
Some oil and gas industry commentators have expressed hesitation regarding Rule 506(d), and have been able to provide only minimal reassurance and professional guidance to oil and gas issuers. Unfortunately, the SEC has not addressed whether the investor general partner will be subject to the strictures of Rule 506(d). Given the SEC’s stated intentions in adopting Rule 506(d), it is likely that the SEC does not intend for investor general partners to be classified as a covered “general partner” in accordance with Rule 506(d). Because many Rule 506 Offerings provide that investor general partners will have no control or voice in the management and operations of the investment fund, those persons or entities do not actually fall into the class of persons that the SEC seeks to regulate—despite the wordplay. However, because the SEC has not explicitly provided guidance on this issue, the Commission could take a literal approach. In support of this contention, the SEC expressed that it purposely adopted its rigid standard in order to avoid a burdensome facts and circumstances approach associated with determining whether an offering was disqualified.
Therefore, a conservative approach would require the issuer to adopt the SEC’s limited exception; Rule 506(d) provides an exception from disqualification when the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The steps an issuer should take to exercise reasonable care will vary according to particular facts and circumstances. (An ironic instruction to the rule given the SEC’s instance that the process be streamlined). The instruction to the rule states that an issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualification exists. To demonstrate an exercise of reasonable care, the issuer could, for example, require prospective investor general partners to make certain representations that they do not run afoul of Rule 506(d)’s requirements, perhaps accomplished by the completion and submission of an investor questionnaire.
The SEC further provided that “if an offering is continuous, delayed or long-lived, the issuer must update its factual inquiry periodically through bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.” This administrative guidance particularly applies to oil and gas funds whose offerings may span long periods and last until the effective depletion of wells and other properties. Accordingly, such issuers would be required under the SEC’s current direction to undertake burdensome and potentially costly diligence depending on the size of the fund.
A more aggressive approach would be to seek a no-action letter from the SEC to elicit the Commission’s blessing on the practice. As of March 2014, representatives from SEC have declined to provide affirmative guidance on the matter or comment.
Because of new guidelines governing bad actors under Rule 506(d), issuers in the oil and gas industry employing a multiple-tier investment scheme should proceed with caution. Until further clarified by the SEC, a lack of administrative guidance around the practice could disqualify the offering if the issuer fails to exercise (and to continually exercise) reasonable care to determine whether a covered person with a disqualifying event participated.
About the authors
Taylor Wirth is an associate in the Nashville office of Baker Donelson. As a member of the firm's Securities & Corporate Governance Group, Wirth assists clients in transactional and general corporate matters, including entity formation, issuance of equity and debt securities, SEC compliance and corporate governance.