The SEC has proposed new regulations to implement the “bad boy” provisions of the Dodd-Frank Act.

Under those provisions, startup companies would have a new, fairly significant due diligence burden to ensure that certain persons[1] are not “bad boys”[2] under the Act.

This new due diligence burden is unfortunate. Under current law, startups can raise capital very efficiently under Rule 506 of Regulation D if they raise money solely from accredited investors. Under Reg D, there is no current burden to conduct “factual inquiries” whether any covered persons are “bad boys.”

The affirmative due diligence obligation created by the new regulations will be new to Reg D offerings, and the SEC admits it might take a substantial amount of time. (“Issuers could potentially devote substantial amounts of time and incur significant costs in making factual inquiries.”) This will slow down capital formation, and slow down job creation. The SEC knows this, and this is the reason it proposed the reasonable care exception.

“We are proposing a reasonable care exception out of a concern that the benefits of Rule 506—which, among other things, is intended to create a cost-effective method of raising capital, particularly for small businesses—may otherwise be substantially reduced.”

I believe that the SEC should back off on the requirement to conduct “factual inquiries” when it considers comments to the draft rules. One of the SEC’s questions in its draft rules was: “Are there any circumstances in which factual inquiry should not be required?”

I believe the answer is yes. And I would suggest that there are at least 2 circumstances in which no factual inquiry should be required: (1) for small offerings (less than $10M), and (2) for offerings in which no broker-dealer or finder is utilized. There are probably other exceptions that ought to be suggested to the SEC as well. If you care about the startup company ecosystem, I encourage you to give this question some thought and write the SEC.