In response to the financial crisis of 2007-2008, Congress passed the Dodd-Frank Act to bolster financial regulations and monitor Wall Street behavior. Included in the Act were amendments to Rule 506 of the Securities Act of 1933. ((Marc A. Leaf, The “Bad Actor” Rule: SEC and Dodd-Frank Act, Nat’l L. Rev. (Sept. 29, 2014), http://www.natlawreview.com/article/bad-actor-rule-sec-and-dodd-frank-act.)) Rule 506 is part of the Regulation D exemption, which allows issuers to raise capital for private offerings. The amendments created the “Bad Actor” rule, which restricts the use of this private offering exemption if the issuer or another covered person is convicted of certain violations. ((Id.)) The rule became effective in 2013. ((Id.))
On August 2014, a $285 million settlement between Citigroup Inc. and the SEC was approved, in response to the bank’s involvement in selling certain collateralized debt. ((Christopher M. Matthews, Appeals Court Says Judge Erred in Blocking SEC-Citigroup Settlement, Wall St. J. (June 4, 2014), http://online.wsj.com/articles/federal-appeals-court-says-judge-erred-in-blocking-sec-citigroup-settlement-1401893898.)) While other large banks were able to settle with the SEC prior to the “Bad Actor” rule becoming effective, Citi failed to do so, and as a result the SEC prohibited the bank from participating in private offerings as soon as the SEC settlement was approved. ((Id.)) In other words, Citi was prohibited from selling “hedge-fund or private-equity investments to high-net worth clients, although it [could] still arrange sales to large institutions.” ((Citi Private Bank Barred from Selling Alts., FINalternatives (Aug. 25, 2014), http://www.finalternatives.com/node/28085.))
Fortunately for Citi, only a month after the settlement, the SEC approved the bank’s request for a waiver to allow the bank to “resume selling investments in hedge funds and private-equity funds to wealthy clients.” ((Andrew Ackerman, SEC Grants Citigroup Waivers, Easing Hedge-Fund Curbs, Wall St. J. (Sept. 30, 2014) http://online.wsj.com/articles/sec-grants-citigroup-waivers-easing-hedge-fund-curbs-1412101382.)) While beneficial for Citi and its wealthy clients, a quick glance at the SEC’s order granting the Rule 506 waiver may raise some eyebrows. The document is only one page, briefly mentions Rule 506, and does not provide a detailed explanation as to why Citi was granted the waiver. ((SEC Release No. 9657 (2014), available at http://www.sec.gov/rules/other/2014/33-9657.pdf.))
Some find the lack of clarification and analysis on the SEC’s part troubling, as the lack of accountability is what led to the financial crisis in the first place. ((SEC Gets a Jump on Holiday Gift-Giving with Waivers for Citigroup – and Coal for Investors, Better Markets, (Oct. 2, 2014, 10:39 AM), https://www.bettermarkets.com/blogs/sec-gets-jump-holiday-gift-giving-waivers-citigroup-%E2%80%93-and-coal-investors#.VDdDTNR4raH [hereinafter Better Markets].)) Citi claimed that it did not engage in intentional misconduct and that the violation only occurred in one transaction, so it should not be punished with the “Bad Actor” rule. ((Id; Ackerman, supra note 6.)). Some commentators speculate that this is obviously a naïve assertion. ((Better Markets, supra note 9)). However, the argument succeeded as the SEC granted the waiver and chose to turn a blind eye on Citi’s repeated violations. In its petition in requesting the waiver, Citi mentioned that the restriction from engaging in private offerings to wealthy clients would discriminate it against its competitors and that this would hurt its business. ((Id.)) But that’s precisely the point of the Rule 506 amendments, hence called the “Bad Actor” rule! This is typically how securities laws work: if an issuer engages in fraud and violations, and the SEC prohibits them from continuing to engage in such behavior, this protects investors and incentives those issuers to change their practices moving forward. A mere slap on the wrist and prohibiting Citi to make private offerings to wealthy clients for about a seven-week stretch (from early August to late September) isn’t what many imagined when the Dodd-Frank Act was passed.