By K. Bradley Rogerson, Esq.

Since 2013, the federal exemption from securities registration provided under Regulation D has disqualified an issuer from utilizing the exemption if the issuer or certain “covered persons” become subject to one of several “bad acts” outlined in Rule 506(d) of Regulation D.[i] For mortgage funds that rely on Regulation D to raise capital to fund their loans, becoming subject to a disqualification event under Rule 506(d) could prove catastrophic for their businesses.

Many of the “bad acts” enumerated in Rule 506(d) relate to orders and actions taken by the Securities and Exchange Commission (SEC) under federal law. One such “bad act”, however, is the entry of a final order by a state securities commission that is based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct.[ii] Fund managers may think there is no risk of disqualification based upon such a provision because they would never intentionally or knowingly defraud, manipulate or deceive their investors. At the federal level this view may be justified because the anti-fraud provisions of Rule 10b-5 prohibiting the use of material misstatements or omissions in securities offerings require an element of scienter (i.e., an intentional or knowing violation of the law).

Issuers of securities in California, however, should be aware that the California Department of Financial Protection and Innovation (“Department” or “DFPI”) is not required to find intentional fraud or a knowing violation of the law to allege violations of California’s version of Rule 10b-5 – California Corporations Code Section 25401 (“Section 25401”). As a result, a California issuer can be cited for violating a California statute that “prohibits fraudulent, manipulative or deceptive conduct” for acts that are done unintentionally and with no knowledge that they might represent a violation of California securities laws.

Unfortunately, this can and does occur even when a fund manager finds itself subject to a routine DFPI examination that is not commenced due to investor losses or complaints. DFPI examiners often find what many practitioners would describe as technical violations or violations based upon unforeseen DFPI interpretations that are clearly not intentional but that are, nonetheless, characterized by the DFPI as violations for “fraud” under Section 25401. The provisions of Regulation D expressly provide the DFPI with the authority to exempt their orders from the disqualifying provisions of Rule 506(d); however, the DFPI has, at times, expressed a blanket policy against including language exempting Section 25401 allegations from Rule 506(d) in its settlement agreements or otherwise.

Funds that rely on Regulation D and that become subject to DFPI review should therefore be mindful of the potential adverse effects of entering into settlement orders with the DFPI that are based upon any Section 25401 allegations. Such orders, whether or not based upon intentional Section 25401 allegations, on their face, will be orders based upon a California law prohibiting fraudulent and manipulative or deceptive conduct and could be deemed a “bad act” disqualifying any future use of Regulation D, entirely.

Private Placement Exemption in California

Regulation D is a safe harbor providing the conditions upon which an issuer of securities can offer and sell securities in a “private offering” exempt from federal registration under Section 4(a)(2) of the Securities Act of 1933 (Federal Act).[iii] Unlike other common federal exemptions, by complying with Rule 506 of Regulation D, a company can offer securities in any amount to an unlimited number of “accredited investors” who can be residents of any state without registering the offering with the SEC. For these reasons, Rule 506 of Regulation D is the most commonly utilized federal exemption from federal registration. Its availability is critical to companies that regularly utilize the exemption to raise capital without incurring the prohibitively high costs of SEC registration.

Securities offered and sold under Regulation D are also “covered securities” subject to the preemptive provisions of Section 18 of the Federal Act.[iv] Consequently, state securities agencies are prohibited from imposing conditions for exempting Regulation D offerings from state qualification other than requiring a filing notice and payment of a filing fee.

In California this exemption is set forth in Corporations Code Section 25102.1(d), which exempts Regulation D offerings, provided the Form D filed with the SEC under Regulation D is also filed in California and the applicable filing fee is paid. The scope of federal preemption applicable to Regulation D offerings, however, does not completely insulate issuers from California oversight. The provisions of Section 18 of the Federal Act expressly preserve for the states the authority to investigate and bring enforcement actions with respect to securities and securities transactions involving fraud or deceit.[v]

Disqualification for ‘Fraud’ under Regulation D

The “bad actor” disqualification provisions of Regulation D are set forth in Rule 506(d) and disqualify any issuer from relying on Regulation D if the issuer or any predecessor, affiliated issuer, director, executive officer, general partner, managing member or any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities (“Restricted Affiliates”) has been the subject of any action enumerated as “bad acts” in the rule. These “bad acts” generally include securities-related criminal convictions, securities industry license revocations, suspensions and limitations, and final judgements and orders related to fraudulent and manipulative securities related conduct.

With respect to DFPI orders, Rule 506(d)(1)(iii) is the most problematic of the “bad acts.” This section disqualifies the use of Regulation D by an issuer (and its Restricted Affiliates) if they are “subject to a final order by a state securities commission … that constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct.”[vi]

The use of the words “fraudulent, manipulative or deceptive” to describe the violations necessary for a state order to constitute a “bad act” seems to suggest that some intentional violation of the law must be present. This language also mirrors the language in the anti-fraud provisions of Rule 10b-5 of the Securities and Exchange Act of 1934 (“Federal Exchange Act”) for which scienter (i.e., an intent to deceive, manipulate or defraud) is an express element.

The problem is that Rule 506(d)(1)(iii) requires an examination of the state law provisions being enforced to determine whether they prohibit “fraudulent, manipulative or deceptive acts.” Unlike Rule 10b-5, the California anti-fraud statute does not require the DFPI to show any fraudulent intent or knowing violation of the law to establish or allege a violation of the statute.

Unintentional Securities Fraud in California

The California version of the anti-fraud provisions of Rule 10b-5 of the Exchange Act is California Corporations Code Section 25401. Section 25041 makes it unlawful to offer or sell a security in California “by means of any written or oral communication that includes an untrue statement of a material fact or omits to state a material fact necessary to make the statements made, in the light of the circumstances under which the statements were made, not misleading.”[vii]

While Section 25401 is based on the anti-fraud provisions of Rule 10b-5 and Rule 10b-5 of the Securities Act, which require an intent to deceive and defraud, the DFPI does not need to show any willful intent on the respondent’s part with respect to fraud claims under Section 25401.[viii] This results in alleged violations of Section 25401 in connection with statements or omissions the DFPI deem misleading, but that were made (or omitted) with no intent to mislead (or any belief by the issuer that anyone, in fact, was actually misled).

Section 25401 allegations arising from routine DFPI audits and not undertaken in response to some complaint often fall within this category. Without an aggrieved party that has been misled, determining what statements or omissions might reasonably be material to – and mislead – investors becomes a very subjective inquiry and the unilateral right of the DFPI to make these assessments can result in “fraud” allegations against respondents trying their best to comply with California’s securities laws but unable to foresee how the DFPI will interpret a particular fact or circumstance.

State Guidance Under Regulation D

The terms of Rule 506(d) anticipate this issue and expressly allow state securities agencies like the DFPI to exempt their orders from the “bad act” provisions of Rule 506(d) in writing, either in the orders themselves or in a separate writing.[ix] The inclusion of this exemption acknowledges that the state agencies, themselves are in the best position to assess the severity and intentionality of the actions that are the subject of a state order. It also allows agencies to exempt an order from Rule 506(d) where mitigating factors are present, including where violations do not involve the type of intentional fraud or malicious misconduct for which disqualification should be appropriate. The DFPI is, therefore, in the best position to assess the intentionality of the actions alleged in a DFPI action and to exempt a California order from the disqualification provisions of Rule 506(d) where appropriate.

The DFPI expressed unwillingness to provide statements with respect to its orders and a policy to not make any determinations with respect to the effect of their orders under Regulation D. This not only creates uncertainty for the affected respondents, but also puts them at a significant disadvantage when defending their right to utilize Regulation D following the issuance of an order including Section 25401 allegations. These orders, on their face, appear to the SEC to be state orders based on 10b-5 like fraud (i.e., intentional fraud). Rule 506(d) allows the DFPI as the state securities agency to exempt the orders if it determines disqualification under Rule 506(b) should not apply. No exemption for settlement orders exists under Regulation D, and without a state exemption, the final order will be commonly viewed as based on intentional fraud. Under these circumstances, defending the exempt nature of the order under Rule 506(d) is problematic at best.

Future Settlement Considerations

California mortgage funds and their managers that rely on Regulation D and become the subject of a DFPI review (“routine” or otherwise) may now need to become far more defensive. Trying to reach a quick settlement for non-fraud types of actions in exchange for a penalty payment far less than the cost of defending the matter previously made sense in many situations. A respondent’s future operations are not imperiled. Settlement orders without an express exemption from the “bad acts” provision of Regulation D, however, significantly affect that calculation. The financial costs of settlement would then include not only the penalty payment that may be required but the potential costs of having the issuer, and all its Restricted Affiliates, disqualified from using Regulation D going forward. For many this cost will prove too great.

 

[i]    15 U.S. Code §77d(a)(2); 17 CFR § 230.506(d). 

[ii]    17 CFR § 230.506(d)(2)(iii).

[iii]    15 U.S. Code §77d(a)(2); 17 CFR § 230.506. 

[iv]   15 U.S. Code §77r

[v]  15 U.S. Code §77r(c).

[vi]  15 U.S. Code §78j; 17 CFR §240.10b-5

[vii]   17 CFR §240.10b-5; CA Cop. Code § 25401 (2023).

[viii]  See, People v. Simon, (1995) 9 Cal. 4th 493, 515-516.  

[ix] 17 CFR § 230.506(d)(2)(iii).

 

 K Bradley Rogerson, Esq. is a Partner at Hanson Bridgett. He can be reached at brogerson@hansonbridgett.com