Previously, CrowdCheck has brought readers the message that no securities law violation is too small to bring on SEC enforcement. It is part of the "broken windows" theory of policing—if you let issuers and brokers get away with the small violations, it sends a message that compliance with securities laws is merely optional. But what happens if instead of a small violation, the SEC has issued an enforcement order against a financial behemoth, who now is subject to the Bad Actor rule prohibitions on participation in offerings utilizing Rule 506 of Regulation D?
Such is the situation that Citigroup now faces. As a result of the delayed entering into an enforcement order with the SEC—order entered in August 2014 for violations that occurred in 2007—Citigroup has been saddled with a determination that it is a Bad Actor under Rule 506(d). Initial analysis has focused on Citigroup's new inability to continue to offer approximately 40 hedge funds to its wealthy clients, but the disqualification does not stop with Citigroup's participation in hedge funds. Any offering occurring under Rule 506 in which Citigroup is a compensated solicitor would also be disqualified.
Other major investment groups have so far avoided Bad Actor disqualifications through fortunate timing or settlement terms. For instance, last year the SEC charged Bank of America with actively defrauding investors in an offering of residential mortgage-backed securities and having violated Sections 5 and 17 of the Securities Act—violations that would trigger the Bad Actor rule. Instead, Bank of America settled with the SEC with only a finding of disclosure failures under Section 13(a) of the Exchange Act, which is not a scienter-based anti-fraud provision and not a triggering event for the Bad Actor rule.
For Citigroup to resume offerings under Rule 506 to its clients, it will have to seek a waiver of the Bad Actor disqualification. While the SEC has already issued waivers in a few instances, it is by no means a sure bet for the company. For example, Commissioner Kara Stein has previously commented that waivers should not be an automatic process. Instead, the SEC should be careful in granting waivers and should consider the initial purpose for the disqualification provision. This is important for large institutions that the SEC may expect to be repeat offenders.
For asset and fund managers of all sizes, the first thing to do is to assess whether there are any concerns about compliance with the Bad Actor rule. One place to start is with a CrowdCheck Bad Actor Report for all the individuals and entities involved in the offering. The report give assurance that CrowdCheck has checked against a broader range of sources that are targeted towards the eight enumerated Bad Acts identified in the rule. Once a potential Bad Act is found, those managers should consider how best to proceed, such as preparing a petition for a waiver.