SEC Adopts Rule Disqualifying Bad Actors from Participation in Rule 506 Offerings

by Poyner Spruill LLP
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In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which, among other things, required the Securities and Exchange Commission (SEC) to adopt rules that would prohibit the use of the Rule 506 exemption for any securities offering in which certain felons and other bad actors (sometimes called “bad boys”) are involved.   The SEC proposed such amendments to Rule 506 on May 25, 2011 and finally adopted the rule amendments July 10, 2013.  The changes will become effective September 23, 2013 (the Effective Date).

Summary of Rule Prior to Amendment

Rule 506 has historically been the most popular securities registration exemption under Regulation D of the Securities Act of 1933, accounting for 90-95% of Regulation D offerings.  Rule 506 allows issuers to sell securities, without SEC or state law registration, to an unlimited number of accredited investors and up to 35 non-accredited investors in unlimited amounts with no mandatory disclosure requirements for accredited investors, subject to certain restrictions on resale and restrictions on general solicitation and advertising.  (Note that the SEC has also recently loosened the restrictions on general solicitation and advertising, which changes will be the topic of a separate article).  Prior to the amendments, certain other exemptions contained bad boy disqualifications, but Rule 506 did not.

Summary of Changes

Under Rule 506, as amended, an issuer cannot rely on the Rule 506 exemption if there has been a "disqualifying event" with respect to the issuer or certain other participants in the offering.  The “covered persons” whose actions could potentially cause the issuer to be disqualified from the exemption are:
  • The issuer, any predecessor of the issuer, or any affiliate 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 promoter connected with the issuer in any capacity at the time of the sale;
  • Any investment manager of an issuer that is a pooled investment fund; or
  • Any person receiving remuneration for solicitation of purchasers in connection with the sale, as well as any general partners, directors, officers, and managing members of such a compensated solicitor.
The “disqualifying events” are as follows:
  • A criminal conviction of a covered person within 10 years of the sale (or five years in the case of the issuer and its predecessors and affiliated issuers) i) in connection with the purchase or sale of a security, ii) involving making of a false filing with the SEC, or iii) arising out of the conduct of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities (Financial Intermediaries).
  • A covered person is subject to a court injunction or restraining order entered within five years of the sale, in connection with i) the purchase or sale of any security, ii)  making of a false filing with the SEC, or iii) arising out of the conduct of the business of a Financial Intermediary.
  • A covered person is subject to a final order from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations, or credit unions that:
    • Bars the covered person from associating with a regulated entity or engaging in the business of the relevant regulated industry; or
    • Is based on fraudulent, manipulative, or deceptive conduct and is issued within 10 years of the sale.
  • A covered person is subject to certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.
  • A covered person is subject to an SEC cease-and-desist order entered within five years before the sale related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
  • A covered person is subject to an SEC stop order or order suspending the Regulation A exemption issued within five years of the proposed sale of securities.
  • A covered person is suspended or expelled from membership in, or suspended or barred from association with a member of,  a registered national securities exchange or registered national or affiliated securities association for conduct inconsistent with just and equitable principles of trade. 
  • A covered person is subject to a U.S. Postal Service (USPS) false representation order issued within five years before the proposed sale of securities, or a temporary restraining order or preliminary injunction with respect to conduct alleged by the USPS to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

Exceptions to Disqualification.

The issuer will not be disqualified if the authority issuing the relevant judgment, order or other disqualifying event listed above determines and advises the SEC in writing that Rule 506 disqualification should not arise from the event.  The court or other authority may include this determination in the relevant judgment, order or decree, or may advise the SEC separately.
The final rule provides an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.   
In addition, the SEC may determine that it is not necessary under the circumstances that an exemption be denied.
Disqualification applies only for disqualifying events that occur after the Effective Date. However, beginning on the Effective Date, disqualifying events that occurred prior to the Effective Date must be disclosed to investors if they otherwise would have resulted in disqualification.

Steps Issuers Should Take:

Issuers should take reasonable steps to confirm that no disqualifying event has occurred with respect to any covered person.  The extent of investigation required in order to meet the “reasonable care” exception will depend on the particular facts and circumstances, but the SEC makes clear that the some factual inquiry is expected.  The SEC has suggested that using questionnaires or certifications may be sufficient in some circumstances, and that it may also be appropriate to consult publicly available databases, such as FINRA’s BrokerCheck.  If the issuer sees “red flags” which would cause it to question the accuracy of the information it has received, then further inquiry may be warranted. 
As noted above, although events that occurred before the Effective Date will not result in disqualification, the issuer should investigate all covered persons with respect to any sales of securities that will occur on or after the Effective Date, since disqualifying events that occurred before the Effective Date must be disclosed to investors.  Such disclosure must be made in writing a reasonable time prior to the sale.
In the context of mergers and acquisitions, acquirers should be sure to inquire regarding any disqualifying events in the due diligence investigation, since the disqualifying events of a predecessor or affiliate could cause the acquirer to become disqualified from using Rule 506 in subsequent securities offerings.

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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