SEC Approves Final Rules Disqualifying Felons and Bad Actors in Rule 506 Securities Offerings | Practical Law

SEC Approves Final Rules Disqualifying Felons and Bad Actors in Rule 506 Securities Offerings | Practical Law

The SEC approved final rules under the Dodd-Frank Act that disqualify securities offerings involving felons and other bad actors from reliance on the safe harbor from registration provided by Rule 506 of Regulation D.

SEC Approves Final Rules Disqualifying Felons and Bad Actors in Rule 506 Securities Offerings

by Practical Law Corporate & Securities
Published on 10 Jul 2013 • USA (National/Federal)
The SEC approved final rules under the Dodd-Frank Act that disqualify securities offerings involving felons and other bad actors from reliance on the safe harbor from registration provided by Rule 506 of Regulation D.
On July 10, 2013, the SEC approved final rules that disqualify securities offerings from relying on the safe harbor provided by Rule 506 of Regulation D if any felons or other bad actors are involved in the offering. The most frequently used safe harbor for exemption from registration under Regulation D, Rule 506 allows issuers to raise unlimited capital from an unlimited number of accredited investors and up to 35 non-accredited investors without having to register the offering with the SEC. The final rules, which are required by Section 926 of the Dodd-Frank Act, define several disqualifying events for issuers and covered persons. As required by Section 926, the final rules are substantially similar to the bad actor disqualification provisions of Rule 262 of Regulation A, which exempts certain small offerings from registration.
Under new Rule 506(d), an issuer will be unable to rely on any Rule 506 exemption for an offering if any person covered by the rule was involved in a "disqualifying event". Persons covered by Rule 506(d) include:
  • The issuer, including predecessors and affiliated issuers.
  • Directors, executive officers, any other officers participating in the offering, general partners and managing members of the issuer.
  • If the issuer is a pooled investment fund, its investment managers, the general partners and managing members of the investment managers, and the directors, executive officers and any other officers participating in the offering of the investment managers and their general partners and managing members.
  • Beneficial owners of 20% or more of the issuer's outstanding voting equity.
  • Any promoters connected with the issuer at the time of sale.
  • Any persons compensated for soliciting investors, any general partners and managing members of such compensated solicitors, and the directors, executive officers and any other officers participating in the offering of such compensated solicitors and their general partners and managing members.
Under Rule 506(d), disqualifying events include:
  • Criminal convictions within ten years before the proposed offering (or five years, in the case of the issuer, its predecessors and affiliated issuers) or court injunctions or restraining orders within five years before the proposed offering:
    • in connection with the purchase or sale of a security;
    • in connection with making a false SEC filing; or
    • arising out of the conduct of certain types of financial intermediaries.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators or federal banking agencies, the CFTC or the National Credit Union Administration that bar the person, at the time of sale, from:
    • associating with a regulated entity;
    • engaging in the business of securities, insurance or banking; or
    • engaging in savings association or credit union activities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators or federal banking agencies, the CFTC or the National Credit Union Administration that are based on fraudulent, manipulative or deceptive conduct and are issued within ten years before the proposed offering.
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect.
  • SEC cease-and-desist orders entered within five years before the proposed offering arising out of any scienter-based anti-fraud violation or violation of Section 5 of the Securities Act in effect at the time of sale.
  • Suspension or expulsion from membership in a self-regulatory organization, which would be disqualifying for the period of suspension or expulsion.
  • SEC stop orders and orders suspending a Regulation A exemption issued within five years before the proposed offering.
  • US Postal Service false representation orders issued within five years before the proposed offering.
The relevant look-back periods in the rule are measured from the date of conviction or sanction, not from the date of the conduct that led to the conviction or sanction.
Rule 506(d) provides certain exceptions from disqualification, including if:
  • Any disqualifying event occurred before the rule's effective date. However, under Rule 506(e), the issuer must disclose in writing any disqualifying events that occurred before the effective date to all prospective purchasers in the offering a reasonable time before completing the sale.
  • An issuer can prove that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. To satisfy this burden, the issuer will need to show that it conducted a factual inquiry tailored to the facts and circumstances of the particular offering and its participants.
  • The court or other authority that issued the order, injunction or decree indicates or advises the SEC that it should not constitute a Rule 506(d) disqualifying event.
In addition, the signature block to Form D is amended to include a certification by Rule 506 issuers that the offering is not disqualified under Rule 506(d).
New Rule 506(d) applies to sales made after the effective date. It will not apply to any sales made before the effective date even if the offering continues after the effective date. However, for offerings that are underway at that time, the new rule will apply to those sales made after that date.
Nothing in the final rules will prevent disqualified Rule 506 offerings from potentially being completed as a registered offering or under another registration exemption or safe harbor that is not subject to bad actor disqualification. Issuers should be able to regain Rule 506 eligibility if they terminate the relationship with the disqualifying person.
The final rules become effective on September 23, 2013.
For information on other approved and proposed changes to Regulation D under the JOBS Act that were issued concurrently with the bad actor rules, see Legal Updates, SEC Approves Final JOBS Act General Solicitation Rules and SEC Proposes Rule Amendments to Evaluate the Rule 506 Market Once General Solicitation is Lifted.
For information on the SEC's other rulemaking activities under the Dodd-Frank Act, see Practice Note, Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
For more information on existing Regulation D offering practice, see Practice Note, Section 4(a)(2) and Regulation D Private Placements.