The SEC Proposes Rules for Disqualification of Felons and Other Bad Actors from Rule 506 Offerings

In addition to final rules and forms implementing the whistleblower program, yesterday the Securities and Exchange Commission also voted, by a margin of 3-2, to propose a series of rule amendments designed to implement Section 926 of the Dodd-Frank Act.

Section 926 requires the adoption of rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is by far the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

The Actors

As proposed the rule amendments would add a new subsection (c) to Rule 506 entitled “Bad Actor Disqualification”, and would apply to bad acts committed by:

  • the company or any predecessor or affiliated company;
  • the company’s officers, directors, general partners or managing members;
  • beneficial owners of 10% or more of a company’s equity securities;
  • any promoter connected to the company in any capacity at the time of sale;
  • any person that has been or will be paid, directly or indirectly, for the solicitation of purchasers in connection with an offering; and
  • any officers, directors, general partners or managing members of a compensated solicitor.

The Bad Acts

The bad acts triggering disqualification would include:

  • criminal convictions in connection with: the purchase or sale of securities; the making of false filings with the Commission; or the business of an underwriter, broker-dealer, municipal securities advisor or paid solicitor of securities, that have occurred within 10 years of the offering (or 5 years in the case of the company, or a predecessor or affiliated company);
  • being subject to a court injunction or restraining order within 5 years of the offering that, at the time of the offering, prohibits a person from engaging in: conduct in connection with the purchase or sale of securities; the making of false filings with the Commission; or the business of an underwriter, broker-dealer, municipal securities advisor or paid solicitor of securities;
  • being subject to a final order by certain state or federal regulators that, at the time of the offering, bars a person from: association with an entity regulated by the Commission; engaging in the business of securities, insurance or banking; engaging in savings association or credit union activities; or is based on a violation of law or regulation that prohibits fraudulent, manipulative or deceptive conduct entered within 10 years of the offering;
  • certain Commission disciplinary orders related to broker-dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or expulsion from membership in, or suspension or bar from associating with, a member of a securities self-regulatory organization;
  • being subject to a refusal order, stop order or order suspending a Regulation A exemption within 5 years of the offering; and
  • being subject to a U.S. Postal Service false representation order within 5 years of the offering.

One Exception

The proposed rule amendments contain a reasonable care exception which provides that a company would not lose the benefit of the Rule 506 exemption, regardless of the existence of a disqualifying bad act, if the company can show that it did not know and, in the exercise of reasonable care, could not have know of the disqualification. Establishing reasonable care requires doing your diligence, i.e., conducting a factual inquiry into whether any disqualification exists; the nature and scope of the inquiry will depend on the facts and circumstances of the offering.

The Controversial Provision

At the Commission’s open meeting, one of the more controversial aspects of the proposed rule amendments was the inclusion of disqualifying events that pre-date enactment of the Dodd-Frank Act in the look-back period for bad acts under the rule.

In other words, as currently proposed, if an actor covered by the new rule amendments entered into a negotiated settlement agreement with a federal or state regulator prior to enactment of the Dodd-Frank Act that settlement agreement will still disqualify the actor from participating in Rule 506 offerings, even if they might not have settled had they known at the time that it would have resulted in disqualification.  For a complete discussion of the issue take a look at pages 44-49 of the Commission’s proposing release.

Both Commissioners Casey and Paredes took issue with this provision and ultimately voted against the proposed rules and amendments.

The Commission is soliciting public comments on the proposed rules and amendments, which are due on or before July 14, 2011.


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