The SEC has adopted final rules to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 926 required the SEC to adopt rules that disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on Rule 506 of Regulation D.

Covered Persons

The disqualification provisions of Rule 506(d) will cover the following persons, which the SEC  refers to as “covered persons”:

• the issuer and any predecessor of the issuer or affiliated issuer;
• any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
• any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
• any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
• any promoter connected with the issuer in any capacity at the time of the sale;
• any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering (which we refer to as a “compensated solicitor”); and
• any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

The final rules include a provision under which events relating to certain affiliated issuers are not disqualifying if they pre-date the affiliate relationship.

Disqualifying Events

The final rules provide the following are disqualifying events if a covered person:

• Has been convicted, within ten years before such sale (or five years, in the case of issuers, their predecessors and affiliated issuers), of any felony or misdemeanor:
  • In connection with the purchase or sale of any security;
  • Involving the making of any false filing with the Commission; or
  • Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities; or
• Is subject to any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice:
  • In connection with the purchase or sale of any security;
  • Involving the making of any false filing with the Commission; or
  • Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities; or
• Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that:
  • At the time of such sale, bars the person from:
    • Association with an entity regulated by such commission, authority, agency, or officer;
    • Engaging in the business of securities, insurance or banking; or
    • Engaging in savings association or credit union activities; or
  • Constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale; or
• Is subject to an order of the SEC entered pursuant to section 15(b) or 15B(c) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(b) or 78o-4(c)) or section 203(e) or (f) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(e) or (f)) that, at the time of such sale:
  • Suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser;
  • Places limitations on the activities, functions or operations of such person; or
  • Bars such person from being associated with any entity or from participating in the offering of any penny stock; or
• Is subject to any order of the SEC entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of:
  • Any scienter-based anti-fraud provision of the federal securities laws, including without limitation section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1)), section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b)) and 17 CFR 240.10b-5, section 15(c)(1) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(c)(1)) and section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)), or any other rule or regulation thereunder; or
  • Section 5 of the Securities Act of 1933 (15 U.S.C. 77e); or
• Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade; or
• Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; or
• Is subject to a United States Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

Reasonable Care Exception

The Rule 506 exemption is still available if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed under the bad actor provision.  The SEC believes the steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances. For example, the SEC anticipates that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering. Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

The SEC also believes the timeframe for inquiry should also be reasonable in relation to the circumstances of the offering and the participants. Consistent with this standard, the SEC stated the objective should be for the issuer to gather information that is complete and accurate as of the time of the relevant transactions, without imposing an unreasonable burden on the issuer or the other participants in the offering. With that in mind, the SEC expects that issuers will determine the appropriate dates to make a factual inquiry, based upon the particular facts and circumstances of the offering and the participants involved, to determine whether any covered persons are subject to disqualification before seeking to rely on the Rule 506 exemption.

The SEC noted issuers should make factual inquiry of the covered persons, but in some cases—for example, in the case of a registered broker-dealer acting as placement agent—it may be sufficient to make inquiry of an entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning the past disciplinary history of the relevant persons.

Waivers

The rules provide the SEC can provide a waiver from the bad actor disqualification upon a showing of good cause and without prejudice to any other action by the SEC, if the SEC determines that it is not necessary under the circumstances that an exemption be denied.

A waiver can also be granted by the court or regulatory authority that entered the relevant order, judgment or decree advises in writing that the bad actor disqualification should not arise as a consequence of such order, judgment or decree.

Disqualifying Events Prior to the Effective Date; Disclosure

The final rule includes a provision specifying that disqualification will not arise as a result of triggering events that occurred before the effective date of the rule amendments.  Although no disqualification results, the rules require disclosure to investors regarding such events.  Issuers will be required to provide disclosure “a reasonable time prior to sale.”

If disclosure is required and not adequately provided to an investor, the SEC does not believe that relief will be available under Rule 508, under which “insignificant deviations” from Regulation D requirements do not necessarily result in loss of the Securities Act exemption with regard to an offer or sale of securities to a particular individual or entity.  The reason is for Rule 508 to apply to an offer or sale of securities, the failure to comply with a Regulation D requirement must not pertain to a term, condition or requirement directly intended to protect that offeree or purchaser.

New Rule 506(e) does, however, provide that the failure to furnish required disclosure on a timely basis will not prevent an issuer from relying on Rule 506 if the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, of the existence of the undisclosed matter or matters. This “reasonable care” exception to the disclosure requirement is similar to the “reasonable care” exception to disqualification described above, and will preserve an issuer’s claim to reliance on Rule 506 if disclosure is required but the issuer can establish that it did not know and in the exercise of reasonable care could not have known of the matters required to be disclosed. The provision also includes an instruction, clarifying that reasonable care requires factual inquiry.

New Form D

Form D has also been revised.   As revised the signature block of the Form D contains a certification, whereby issuers claiming a Rule 506 exemption confirm that the offering is not disqualified from reliance on Rule 506 as a result of the bad actor disqualification provisions.