Business and Corporate: SEC Adopts “Bad Actor” Rules That Prevent Use of the Rule 506 Exemption
On September 23, 2013, Sections 506(d) and 506(e) of Regulation D under the Securities Act of 1933 became effective regarding “bad actors.” Section 506 provides a commonly used exemption from the requirement under the Securities Act of 1933 to register offerings for sales of securities.
If a “bad act” occurs after September 23, 2013, and a “bad actor” is involved in the offering, then reliance on the Section 506 exemption is not available. If a “bad act” occurred prior to September 23, 2013, and a “bad actor” is involved in the offering, then the Section 506 exemption may be used but the issuer must furnish to each purchaser prior to sale a written description of any “bad acts” that occurred during any look back period.
The scope of persons involved in an offering that will cause disqualification for a “bad act” is quite broad. These include, the issuer; any predecessor to the issuer; any affiliated issuer; any director, executive officer, or other officer participating in the offering, general partner or managing member of the issuer; any promoter connected with the issuer in any capacity at the time of sale; any investment manager of an issuer that is a pooled investment fund; any person that is paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of such securities; any general partner or managing member of any such investment manager or solicitor; any director, executive officer, or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.
The scope of covered persons also includes any beneficial owner of 20% or more of the issuer’s outstanding voting securities, calculated on the basis of voting power.
Disqualifying events or “bad acts” include the following:
|Bad Act||Look Back Period|
|Any criminal conviction: in connection with the purchase or sale of any security or making of a false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor or paid solicitor of purchasers.||10 years (5 years for issuers, predecessors or affiliated issuers).|
|Any court order, judgment or decree: enjoining or restraining engaging in conduct or practice in connection with purchase or sale of any security or making of a false filing with the SEC; or in connection with the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor or paid solicitor of purchasers.||5 years.|
Any final order of a state securities, banking or financial authority; a federal banking agency; the Commodity Futures Trading Commission; or the National Credit Union Administration that:
Bars association with a regulated entity or bars engaging in securities, banking, insurance or savings institution activities; or
Constitutes a final order based on a violation of a law that prohibits fraudulent, manipulative or deceptive conduct.
|Longer of the duration of any bar or 10 years from a final order prohibiting fraudulent, manipulative or deceptive conduct.|
Any SEC order under section 15(b) or 15B(c) of the Exchange Act or section 203(e) or (f) of the Investment Advisors Act that:
Suspends or revokes registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on such activities; or bars association with an entity, or from participating in offering of any penny stock.
|While order is in effect.|
|Any SEC order to cease and desist from violation of scienter-based anti-fraud provisions including section 5 or 17(b) of the Securities Act or section 10(b) or 15 (c)(1) of the Exchange Act or section 206(1) of the Investment Advisors Act||5 years from entry of order.|
|Suspension or expulsion from registered national securities exchange or a registered national securities association (FINRA).||While suspension or expulsion is in effect.|
|Any Regulation A refusal order or stop order.||5 years.|
|Any U.S. Postal Service false representation order.||Longer of duration of order or 5 years.|
The disqualification does not apply if:
• The SEC determines that denial of the exemption is not necessary upon a showing of good cause;
• The court or regulatory authority issuing the relevant order or decree advises in writing that the disqualification should not arise as a consequence of the order or decree; or
• The issuer does not know, and through exercise of reasonable care could not know, of events resulting in disqualification.
Issuers, advisors and placement agents relying on Section 506 need to assess their exposure to “bad actor” disqualification. Section 506(d) provides that an issuer cannot rely on lack of knowledge of a “bad actor” unless the issuer has made a factual inquiry into whether any disqualification event exists.
Issuers, advisors and placement agents need to create written evidence of their factual inquiry of all relevant persons who are covered by the scope of the disqualification rule. First, issuers, advisors or placement agents should identify and list all covered persons. This list should be reviewed and updated frequently. Next, all covered persons should be required to respond in writing to a questionnaire asking if the responding person is affected by any “bad acts.” A good practice would require such responses to be updated periodically. When hiring any employees or engaging services of any contractor, candidates should be asked to respond in writing to a similar questionnaire.
This alert is not intended to provide legal advice or to permit reliance on the content. Issuers, advisors and placement agents should review the actual provisions of Section 506. The Firm is available to answer any questions concerning the “bad actor” provisions.