New Rule 506(d) "Bad Actor" Disqualification - A Continuous Diligence Headache for Emerging Companies

by McCarter & English, LLP

As required by the Dodd-Frank Act, the SEC on July 10, 2013, adopted final Rule 506(d) to "disqualify felons and other bad actors" from Regulation D private offerings.  New Rule 506(d) identifies persons and triggering events that can disqualify an offering from relying on Rule 506 - the most widely used registration exemption for private placements of securities, resulting in billions of dollars of investment proceeds each year.  The new rule will have important consequences for emerging companies - and not just when they are raising capital. 

Rule 506 has long appealed to companies for several reasons:  no limits on the amount of capital that can be raised or the number of investors (if accredited) and pre-emption of state securities (blue sky) regulation.  Traditionally, compliance with Rule 506 wasn't difficult, and it could safely be ignored except when raising money. New Rule 506(d) changes the landscape.  If a company cannot rely on Rule 506, it loses the most usable and cost-efficient means to raise money, especially in large amounts.  Just as important, disqualification will trigger state law compliance for each state in which the securities are offered - sometimes a daunting task.

Even before Rule 506(d) becomes effective on September 23, 2013, companies that are planning to conduct a private offering must learn the rule and keep it in mind as they seek investors, recruit officers and directors, and work with certain other persons and entities.  For offerings after that date, if someone turns up as a "bad actor," Rule 506 is no longer available.

The events triggering disqualification are clearly stated in the rule (more detail below) and, broadly speaking, involve criminal convictions, court injunctions or final orders of the SEC and other federal and state government agencies arising from past noncompliant offers and sales of securities, any false SEC filing, or violative conduct in the securities industry.  The persons and entities to which this applies - so-called covered persons - that can disqualify a company, however, is a long laundry list and not always so obvious in its application. 

"Covered persons" includes, among others, the company itself and any predecessor entity, its directors and executive officers as well as officers who participate in an offering.  It also includes 20% shareholders, i.e., beneficial owners of at least 20% of the company's outstanding equity securities regardless of class and calculated based on voting power.  Voting securities includes preferred stock or other securities conferring the right to elect directors or otherwise influence management or control corporate direction.  Another group of covered persons are promoters, a broad category that captures persons and entities that have relationships with the company or its Rule 506 offering.  Promoters are persons and entities that helped to found the company as well as anyone, in connection with starting the business, who becomes a 10% shareholder or receives 10% of the proceeds of any class of the company's securities.

The "sting" of the triggering event for a "bad actor" that disqualifies a company from Rule 506 is long: five years for a company or its predecessor, or a related "covered person" (see above), convicted of a felony or misdemeanor in connection with the purchase or sale of a security, or making a false filing with the SEC, or arising out of activities as a securities professional.  A similar five-year period is triggered for any person subject to a court order enjoining the person from engaging in certain practices that violate the securities laws.  Disqualification also applies to persons who are barred or suspended by various federal and state agencies from involvement with a range of financial institutions or subject - within the five preceding years - to a final order arising from violation of laws that prohibit fraudulent, manipulative or deceptive conduct.  The rule identifies other disqualifying events as well.

The potentially harsh results of the rule can be avoided, but advance planning is in order.  The most practical will be if a company can demonstrate that it didn't know about the disqualifying event and could not have known despite exercising reasonable care.  Rule instructions make clear that establishing reasonable care requires actual evidence of making a factual inquiry - a quick oral inquiry isn't likely to suffice.  If the disqualifying event occurred before September 23, 2013 (when the rule becomes effective), reliance on Rule 506 isn't prohibited, but all prospective investors must be informed, which of course could undermine their interest.  A company can also seek relief from the SEC in a showing of good cause that the Rule 506 exemption shouldn't be denied, or from the relevant court or state agency that its order or decree should not be construed to bar reliance on the exemption.  Each of these takes time and resources, and can add uncertainty to the outcome of the offering.

As noted above, planning ahead is the most prudent approach.  That could mean, for example, detailed questionnaires required from each covered person, whether as part of the hiring or appointment process, or when an outside adviser is engaged.  There could be hardly anything worse during a private placement than a belated discovery that a director or officer, or much-desired investor, has a disqualification "skeleton" in the closet.  Early-stage companies often don't bother with background checks - maybe they'll need to reconsider.  New Rule 506(d) will also require ongoing attention.  For example, a company may consider a periodic inquiry (perhaps similar to questionnaires public companies use to verify annual proxy statement information) to be sure that no disqualifying event has occurred in the preceding year.  It also means monitoring the 20% beneficial ownership threshold if, for example, a current shareholder enlarges its stake in the company.  For good or ill the SEC, in implementing Dodd-Frank, forces most emerging companies to keep their eyes on Rule 506 nearly all the time.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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